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Full text of "Summary of conference agreement on H.R. 3838 : Tax Reform Act of 1986"

[JOINT COMMITTEE PRINT] 



SUMMARY OF CONFERENCE AGREEMENT 

ON H.R. 3838 

(TAX REFORM ACT OF 1986) 



Prepared by the Staff 



OF THE 



JOINT COMMITTEE ON TAXATION 




AUGUST 29, 1986 



U.S. GOVERNMENT PRINTING OFFICE 
63-115 WASHINGTON: 1986 JCS-16-86 



For sale by the Superintendent of Documents, U.S. Government Printing Office 
Washington, DC 20402 



CONTENTS 



Page 

[ntroduction xiii 

rille I. Individual Income Tax Provisions 1 

A. Basic Rate Structure 1 

1. Tax rate schedules 1 

2. Standard deduction 2 

3. Personal exemption 2 

4. Inflation adjustments 3 

5. Repeal of two-earner deduction 3 

6. Repeal of income averaging 3 

B. Earned Income Credit 3 

C. Exclusions from Income 4 

1. Unemployment compensation benefits 4 

2. Scholarships and fellowships 4 

3. Prizes and awards 4 

D. Deductions for Personal Expenditures 5 

1. Itemized deduction for State and local sales taxes. 5 

2. Charitable deduction for nonitemizers 5 

3. Medical expense deduction 5 

4. Adoption expenses 5 

5. Deductibility of mortgage interest and taxes allo- 

cable to certain housing allowances 5 

E. Expenses for Business or Investment 5 

1. Meals, travel, and entertainment expenses 5 

2. Employee business expenses, investment ex- 

penses, and other miscellaneous itemized deduc- 
tions 6 

F. Political Contributions Tax Credit 6 

Title II. Capital Cost Provisions 7 

A. Cost Recovery: Depreciation; ITC; Finance Leases 7 

1. Depreciation and expensing 7 

2. Regular investment tax credit 8 

3. Finance leasing 8 

B. Limit on General Business Credit 8 

C. Research and Development 8 

L Tax credit for increasing research expenditures .... 8 

2. Augmented charitable deduction for donations of 

scientific equipment 9 

3. Tax credit for orphan drug clinical testing 9 

D. Rapid Amortization Provisions 9 

(III) 



IV 

1. Trademark and trade name expenditures 

2. Railroad grading and tunnel bores 

3. Bus operating authorities 

4. Removal of architectural and transportation bar- 

riers to the handicapped and elderly 

E. Real Estate Provisions 

1. Tax credit for rehabilitation expenditures 

2. Tax credit for low-income rented housing 

F. Merchant Marine Capital Construction Fund 

Title III. Capital Gains and Losses 

A. Individual Capital Gains 

B. Corporate Capital Gains 

C. Incentive Stock Options 

D. Straddles 

Title IV. Agriculture, Timber, Energy, and Natural Re- 
sources 

A. Agricultural Provisions 

1. Special expensing provisions 

2. Dispositions of converted wetlands and highly 

erodible croplands 

3. Preproductive period expenses of farmers 

4. Prepayments of farming expenses 

5. Treatment of discharge of indebtedness income 

for certain farmers 

B. Timber Provisions 

1. Preproductive expenses of growing timber 

2. Reforestation expenses 

3. Capital gains for timber 

C. Oil, Gas, and Geothermal Properties 

1. Intangible drilling costs 

2. Percentage depletion for bonuses and advance 

royalties 

D. Hard Minerals 

1. Exploration and development costs 

2. Percentage depletion of hard mineral deposits 

•;■ 3. Gain on disposition of interest in mineral proper- 
ties 

E. Energy-Related Tax Credits and Other Incentives 

1. Business energy tax credits 

2. Alcohol fuels 

3. Neat alcohol fuels 

4. Taxicab fuels tax exemption 

Title V. Tax Shelters; Interest Expense 

A. At-Risk Rules 

B. Limitations on Losses and Credits from Passive Ac- 

tivities 

C. Interest Deduction Limitation 

Title VL Corporate Taxation 



Page 

^' A. Corporate Tax Rates 19 

B. Corporate Dividends Paid Deduction 19 

C. Corporate Dividends Received Deduction 19 

D. Extraordinary Dividends 19 

E. Dividend Exclusion for Individuals 20 

F. Stock Redemption Payments 20 

G. Limitations on Net Operating Loss (NOL) Carryovers. 20 
H. Gain or Loss on Liquidating Sales and Distributions... 21 

I. Allocation of Purchase Price in Certain Asset Sales 21 

J. Related Party Sales 21 

K. Amortizable Bond Premium 22 

L. Cooperative Housing Corporations 22 

M. Real Estate Investment Trusts 22 

N. Mortgage-Backed Securities 23 

O. Regulated Investment Companies 23 

P. Definition of Personal Holding Company Income 24 

rule VII. Minimum Tax Provisions 25 

A. Individual Minimum Tax 25 

B. Corporate Minimum Tax 25 

ritle VIII. Accounting Provisions 27 

A. Limitations on the Use of the Cash Method of Ac- 

counting 27 

B. Simplified Dollar Value LIFO Method for Certain 

Small Businesses 27 

C. Installment Sales 27 

D. Capitalization of Inventory, Construction, and Devel- 

opment Costs 28 

E. Long-Term Contracts 28 

F. Reserves for Bad Debts 28 

G. Taxable Year of Partnerships, S Corporations, and 

Personal Service Corporations 29 

H. Special Treatment of Certain Items 29 

1. Qualified discount coupons 29 

2. Utilities using accrual accounting 29 

3. Contributions in aid of construction 29 

4. Discharge of indebtedness of solvent taxpayers 30 

ritle IX. Financial Institutions 31 

A. Reserve for Bad Debts 31 

1. Commercial banks 31 

2. Thrift institutions 31 

B. Interest on Debt to Purchase or Carry Tax-Exempt 

Obligations 31 

C. Net Operating Loss Carryovers of Financial Institu- 

tions 32 

D. Reorganizations of Financially Troubled Thrift Insti- 

tutions 32 

E. Losses on Deposits in Insolvent Financial Institutions 32 

Title X. Insurance Products and Companies 33 



VI 

A. Insurance Policyholders 

1. Exclusion for interest on installment pajonents of 

life insurance proceeds 

2. Treatment of structured settlement agreements.,.. 

3. Treatment of interest on loans from life insur- 

ance policies 

4. Treatment of policies to cover prearranged funer- 

al expenses 

5. Deduction for nonbusiness casualty losses 

B. Life Insurance Companies 

1. Special life insurance company deduction 

2. Tax-exempt organizations engaged in insurance 

activities 

3. Physicians' and surgeons' mutual protection asso- 

ciations 

4. Operations loss deduction of insolvent companies.. 

C. Property and Casualty Insurance Companies 

1. Inclusion in income of 20 percent of unearned 

premium reserves 

2. Treatment of certain dividends and tax-exempt 

income 

3. Treatment of loss reserves 

4. Repeal of protection against loss account 

5. Revision of special treatment for small compginies 

6. Study of property and casualty insurance compa- 

nies 

Title XI. Pensions and Deferred Compensation; Employee 
Benefits; ESOPs 

^[ A. Treatment of Tax-Favored Savings :... 

1. Individual retirement arrangements (IR As) 

-' -1 2. Qualified cash or deferred arrangements (sec. 

401(k) plans) 

^^ 3. Employer matching contributions and employee 
"^^ contributions 

4. Unfunded deferred compensation plans of State 

and local governments 

5. Deferred annuity contracts 

6. Elective contributions under tax-sheltered annu- 

ities (sec. 403(b)) 

7. Simplified employee pensions (SEPs) 

8. Salary reduction permitted under section 

501(c)(18) plans 

B. Minimum Standards for Qualified Plans 

1. Coverage requirements for qualified plans 

2. Minimum participation requirement 

3. Nondiscrimination rules applicable to tax-shel- 

tered annuities 

4. Integration with Social Security 

5. Uniform definition of highly compensated em- 
r ployees 

6. Determining top-heavy status 

7. Includible compensation 



VII 

Page 

8. Benefit forfeitures 45 

9. Vesting standards 45 

C. Treatment of Distributions 46 

1. Uniform minimum distribution rules 46 

2. Treatment of distributions 46 

3. Taxation of early distributions from qualified re- 

tirement plans 47 

4. Tax-sheltered annuities 47 

5. Loans under qualified plans 47 

D. Tax Deferral Under Qualified Plans 48 

1. Overall limitations on contributions and benefits 

under qualified plans 48 

2. Deductions for contributions to qualified plans 49 

3. Excise tax on reversion of qualified plan assets to 

employer 49 

E. Miscellaneous Pension and Deferred Compensation 

Provisions 49 

1. Discretionary contribution plans 49 

2. Requirement that collective bargaining agree- 

ments be bona fide 49 

3. Penalty for overstatement of pension liabilities 50 

4. Treatment of certain fishing boat crews as self- 

employed individuals 50 

5. Cash out of certain accrued benefits 50 

6. Time required for plan amendments, issuance of 

regulations, and development of section 401(k) 

model and master prototype plans 50 

7. Exemption from the survivor benefit require- 

ments of the Retirement Equity Act of 1984 51 

8. Employee leasing 51 

F. Employee Benefit Provisions 51 

1. Nondiscrimination rules for certain statutory em- 

ployee benefit plans and cafeteria plans 51 

2. Deductibility of health insurance costs of self-em- 

ployed individuals 52 

3. Exclusions for educational assistance programs, 

qualified group legal services, and dependent 

care assistance programs 53 

4. Faculty housing 53 

5. Health benefits for retirees 53 

6. Accrued vacation pay 53 

G. Employee Stock Ownership Plans (ESOPs) 53 

1. Repeal of employee stock ownership tax credit 53 

2. Certain additional tax benefits relating to ESOPs . 54 

3. Changes in qualification requirements relating to 

ESOPs 54 

Title XII. Foreign Tax Provisions 56 

A. Foreign Tax Credit 56 

1. Foreign tax credit limitation 56 

2. Credit for high withholding taxes on interest 56 

3. Deemed-paid credit 56 



vni 

4. Effect of foreign and U.S. losses on foreign tax 

credit 

5. Subsidies 

6. Carrybacks 

B. Source Rules 

1. Income from purchase and sale of inventory-type 

property 

2. Income from intangible property 

3. Income from sale of other personal property 

4. Transportation income 

5. Other offshore income and income earned in 

space 

6. Dividend and interest income 

7. Allocation of interest and other expenses (other 

than R&D) 

8. Allocation of R&D expenses 

9. Effective date 

C. Taxation of U.S. Shareholders of Foreign Corpora- 

tions 

1. Tax haven income generally 

2. Determination of U.S. control of foreign corpora- 

tions , 

3. De minimis tax haven income rule 

4 . Possessions-chartered corporations 

5. Application of accumulated earnings tax (AET) 

and personal holding company (PHC) tax to for- 
eign corporations 

6. Deduction for dividends received from foreign cor- 

porations 

7. Delayed effective date for 1984 amendment to 

earnings and profits rules 

8. Effective date 

D. Special Tax Provisions for U.S. Persons 

1. Possession tax credit 

2. Taxation of certain employees in Panama 

3. Exclusion for private sector earnings of Ameri- 

cans abroad 

4. Transfers of intangibles to related parties outside 

of the U.S 

5. Compliance provisions applicable to U.S. persons 

resident abroad 

6. Foreign investment companies (FICs) 

E. Treatment of Foreign Taxpayers 

1. Branch profits tax 

2. Retain character of effectively connected income .. 

3. Tax-free exchanges by expatriates 

4. Excise tax on insurance premiums paid to foreign 

insurers 

5. Reporting by foreign controlled corporations 

6. Foreign investors in U.S. partnerships 

7. Income of foreign governments 

8. Transfer prices for imports 

9. Dual resident companies 



IX 

Page 

10. Earnings stripping: interest paid to related tax- 
exempt parties 63 

11. Definition of resident alien 63 

F. Foreign Currency Exchange Gain or Loss 63 

G. Tax Treatment of Possessions 63 

1. U.S. Virgin Islands 63 

2. Guam, the Commonwealth of the Northern Mari- 

ana Islands (CNMI), and American Samoa 64 

3. Effective date 64 

Title XIII. Tax-Exempt Bonds 65 

A. Tax-Exempt Bond Provisions 65 

1. Bonds to finance general governmental oper- 

ations 65 

2. Exceptions for certain private activity bonds 65 

3. State volume limitation 66 

4. Arbitrage and related restrictions 67 

5. Changes in use of bond-financed facilities 67 

6. Miscellaneous requirements 68 

7. Effective dates 68 

B. General Stock Ownership Corporations (GSOCs) 68 

Title XIV. Trusts and Estates; Minor Children; Gift and 

Estate Taxes; Generation-Skipping Transfer Tax 69 

A. Income Taxation of Trusts and Estates 69 

1. Tax rate schedule 69 

2. Grantor trust rules 69 

3. Taxable years of trusts 69 

4. Trusts and estates to make estimated payments 

of income tax 69 

B. Unearned Income of Children Under Age 14 69 

C. Gift and Estate Taxes 70 

1. Filing information for estate tax current use 

valuation elections 70 

2. Gift and estate tax deductions for certain conser- 

vation easement donations 70 

3. Special relief for the Estate of James H.W. 

Thompson 70 

D. Generation-Skipping Transfer Tax 70 

Title XV. Compliance and Tax Administration 71 

A. Penalties 71 

1. Penalty for failure to file information returns or 

statements 71 

2. Increase in penalty for failure to pay tax 71 

3. Negligence and fraud penalties 71 

4. Penalty for substantial understatement of tax li- 

ability 71 

B. Interest Provisions 71 

1. Differential interest rate 71 

2. Interest on accumulated earnings tax 72 

C. Information Reporting Provisions 72 



t:< 



X 

1. Real estate transactions 

2. Persons receiving Federal contracts 

3. Royalties 

4. Taxpayer identification number of dependents 

5. Modification of separate mailing requirement 

6. Tax-exempt interest 

7. State and local taxes 

D. Tax Shelters 

1. Tax shelter user fee 

2. Tax shelter registration 

3. Tax shelter penalties 

4. Tax shelter interest 

E. Estimated Tax Payments 

F. Tax Litigation and Tax Court 

1. Awards of attorney's fees in tax cases 

2. Exhaustion of administrative remedies 

3. Report to Congress on Tax Court inventory 

4. Tax Court provisions 

G. Tax Administration Trust Fund 

H. Teix Administration Provisions 

1. Suspend statute of limitations during prolonged 
dispute over third-party records 

2. Authority to rescind notice of deficiency 

3. Authority to abate interest 

4. Suspension of compounding where underlying in- 
terest is suspended 

. :> 5. Additional exemption from levy 

6. Rules applicable to forfeiture 

7. Certain recordkeeping requirements 

8. Disclosure of return information to certain large 

cities 

I. Modification of Withholding Schedules 

J. Report on Return-Free Tax System 

Title XVI. Exempt and Nonprofit Organizations 

A. Exchanges and Rentals of Membership Lists of Cer- 

tain Tax-Exempt Organizations 

B. Distribution of Low-Cost Articles by Charities 

C. Expansion of Exception from Unrelated Business 

Income Tax for Qualified Trade Shows 

D. Tax-Exempt Status for Certain Title-Holding Compa- 

nies 

E. Exception to Membership Organization Deduction 

Rules 

F. Tax-Exempt Status for Technology Transfer Organi- 

zation 

Title XVIL Other Provisions 

A. Targeted Jobs Tax Credit 

. B. Collection of Diesel Fuel and Gasoline Excise Taxes.... 
C. Social Security and FUTA Provisions 

1. Allow ministers to reelect social security coverage 

2. FUTA for certain Indian tribes 



XI 

Page 

3 . Treatment of certain technical personnel 78 

D. Tax Code Reference 79 

E. Miscellaneous Provisions 79 

1. Foster care payments 79 

2. Rules for spouses of Vietnam MIAs 79 

3. Exempt certain reindeer income from tax 79 

4. Certain quality control studies for AFDC and 

Medicaid 79 

rule XVIII. Technical Corrections 80 



INTRODUCTION 

This pamphlet ^ provides a title-by-title summary of the principal 
provisions of H.R. 3838 (Tax Reform Act of 1986), as agreed to by 
:he House-Senate Conferees on August 16, 1986. As a general rule, 
:his pamphlet does not describe agreements of the Conferees not to 
adopt a particular provision that was only in the House-passed bill 
3r only in the Senate-passed bill, i.e., agreements to retain present 
[aw on particular issues. 

This pamphlet is provided for the use of the Members of the 
House and the Senate. The official legislative document on the con- 
ference decisions on H.R. 3838 will be the conference report on the 
jill (including the Statement of Managers explaining the confer- 
ence decisions). 

(XIII) 



' This pamphlet may be cited as follows: Joint Committee on Taxation, Summary of Confer- 
ence Agreement on H.R. 3838 (Tax Reform Act of 1986) (JCS-16-86), August 29, 1986. 



SUMMARY OF THE CONFERENCE AGREEMENT 
Title I. Individual Income Tax Provisions 
A. Basic Rate Structure 

1. Tax rate schedules 

New schedules. — The conference agreement provides two-bracket 
rate schedules for individual taxpayers, with rates of 15 and 28 per- 
cent. This new structure replaces the present-law structure of up to 
15 brackets, with a top rate of 50 percent. The new structure goes 
into effect beginning in 1988; transitional rate schedules are pro- 
vided for 1987 returns. 

The 28-percent rate begins at taxable income levels of $29,750 for 
married individuals filing jointly and surviving spouses, $23,900 for 
heads of household, $17,850 for single individuals, and $14,875 for 
married individuals filing separately. (Taxable income equals ad- 
justed gross income less personal exemptions and less the standard 
deduction or itemized deductions.) Beginning in 1989, the taxable 
income amounts at which the 28-percent rate starts will be adjust- 
ed for inflation. 

Rate adjustment. — Beginning in 1988, the benefit of the 15-per- 
cent bracket is phased out for taxpayers having taxable income ex- 
ceeding specified levels. The income tax liability of such taxpayers 
is increased by five percent of their taxable income within specified 
ranges. 

The rate adjustment occurs between $71,900 and $149,250 of tax- 
able income for married individuals filing jointly; between $61,650 
and $123,790 of taxable income for heads of household; between 
$43,150 and $89,560 of taxable income for single individuals; and 
between $35,950 and $113,300 of taxable income for married indi- 
viduals filing separately. These amounts will be adjusted for infla- 
tion beginning in 1989. 

The maximum amount of the rate adjustment generally equals 
13 percent of the maximum amount of taxable income within the 
15-percent bracket applicable to the taxpayer (for a married indi- 
vidual filing separately, within the 15-percent bracket applicable 
for married taxpayers filing jointly). Thus, if the maximum rate ad- 
justment applies, the 28-percent rate in effect applies to all of the 
taxpayer's taxable income, rather than only to the amount of tax- 
able income above the breakpoint. 

Transitional rate structure for 1987. — For taxable years begin- 
ning in 1987, five-bracket rate schedules are provided, as shown in 
the table below. Neither the rate adjustment (described above) nor 
the personal exemption phaseout (described below) applies for 1987. 



(1) 



Taxable income brackets 



Tax rate Married, filing: Heads of Siniries 

joint returns household * 

11% 0-$3,000 0-$2,500 0-$l,800 

15% 3,000-28,000 2,500-23,000 1,800-16,800 

28% 28,000-45,000 23,000-38,000 16,800-27,000 

35% 45,000-90,000 38,000-80,000 27,000-54,000 

38.5% Above 90,000 Above 80,000 Above 54,000 



For married individuals filing separate returns, the taxable 
income bracket amounts for 1987 begin at one-half the amounts for 
joint returns. 

2. Standard deduction 

Increased amounts for all taxpayers. — Under the conference 
agreement, the standard deduction replaces the zero bracket 
amount (ZBA). Effective in 1988, the standard deduction amounts 
are $5,000 for married individuals filing jointly and for surviving 
spouses; $4,400 for heads of household; $3,000 for single individuals; 
and $2,500 for married individuals filing separately. Beginning in 
1989, these amounts will be adjusted for inflation. 

Additional amount for the elderly or blind. — An additional stand- 
ard deduction amount of $600 is allowed for an elderly or blind in- 
dividual who is married ($1,200 for a married individual who is 
both elderly and blind). An additional standard deduction amount 
of $750 is allowed for an unmarried individual who is elderly or 
blind ($1,500 if both). For elderly or blind taxpayers only, the new 
standard deduction amounts (listed in the preceding paragraph) 
and the additional $600 or $750 standard deduction amounts are ef- 
fective beginning in 1987. Beginning in 1989, the $600 and $750 ad- 
ditional standard deduction amounts will be adjusted for inflation. 

Standard deduction for 1987. — For all individual taxpayers other 
than elderly or blind individuals, the standard deduction amounts 
for 1987 are $3,800 for married individuals filing jointly and surviv- 
ing spouses; $2,570 for heads of household and single individuals; 
and $1,900 for married individuals filing separately. 

3. Personal exemption 

Exemption amount. — The conference agreement increases the 
personal exemption for each individual, the individual's spouse, 
and each dependent to $1,900 for 1987, $1,950 for 1988, and $2,000 
in 1989. Beginning in 1990, the $2,000 personal exemption amount 
will be adjusted for inflation. 

Beginning in 1988, the personal exemption amounts are phased 
out for taxpayers having taxable income exceeding specified levels. 
The income tax liability of such taxpayers is increased by five per- 
cent of taxable income within certain ranges. This reduction in the 
personal exemption amounts starts at the taxable income level at 
which the benefit of 15-percent rate is totally phased out (see "Rate 
adjustment," above). For example, in the case of married individ- 
uals filing joint returns, in 1988 the personal exemption phaseout 



begins at taxable income of $149,250. The exemption is totally 
phased out at $10,920 per exemption above that amount in 1988 
and $11,200 per exemption above that amount in 1989. For exam- 
ple, in the case of married individuals filing jointly who have two 
dependent children, in 1988 the four $1,950 personal exemptions 
are completely phased out at taxable income of $192,930. 

Relief for elderly. — The additional personal exemptions in 
present law for the elderly and for blind individuals are repealed, 
starting in 1987. As stated above, the conference agreement pro- 
vides an additional standard deduction amount of $600 or $750 for 
an elderly or blind individual, starting in 1987. In addition, the in- 
creased standard deduction amounts generally applicable in 1988 
(e.g., $5,000 for married individuals filing jointly) apply for elderly 
or blind individuals starting in 1987. The present-law tax credit for 
the elderly and certain disabled individuals is retained. 

Rules for dependents. — The conference agreement provides that 
the personal exemption is not allowed to an individual who is eligi- 
ble to be claimed as a dependent on another taxpayer's return (for 
example, where a child is eligible to be claimed as a dependent on 
his or her parents' return). This rule is intended to preclude the 
doubling of tax benefits allowed under present law, where the per- 
sonal exemption for a child can be claimed by the parents on their 
return and also by the child on his or her return. However, unlike 
the present-law rule that allows such dependent to use the stand- 
ard deduction (ZBA) only to offset earned income, the conference 
agreement provides that the dependent may use up to $500 of his 
or her standard deduction to offset unearned income. These rules 
for dependents are effective beginning in 1987. 

4- Inflation adjustments 

Inflation adjustments (indexing) to the rate brackets, standard 
deduction (and the $600 or $750 additional standard deduction), and 
personal exemption will be made beginning in the years stated 
above. These adjustments will be rounded down to the nearest mul- 
tiple of $50. The 12-month period for measuring inflation will end 
August 31 (rather than September 30) of each year. 

5. Repeal of two-earner deduction 

The deduction for two-earner married individuals is repealed, be- 
ginning in 1987. Adjustments made in the standard deduction for 
married individuals filing jointly and in the relationship of the rate 
schedules for unmarried individuals and married individuals filing 
joint returns are intended to compensate for the repeal of this pro- 
vision. 

6. Repeal of income averaging 

The conference agreement repeals income averaging, beginning 
in 1987, in light of the new rate structure. 

B. Earned Income Credit 

The conference agreement increases the refundable earned 
income credit from 11 percent of the first $5,000 of earned income 
to 14 percent of the first $5,714 of earned income, beginning in 
1987. (The earned income credit provides tax relief to low-income 



63-115 0-86-2 



4 

working individuals with children.) Thus, the maximum credit is 
increased from $550 to $800. In addition, the conference agreement 
increases the credit phase-out to apply at higher income levels 
($9,000-$17,000) than under present law, effective beginning in 
1988. 

As a further liberalization of present law, the maximum dollar 
amount of earned income against which the credit applies ($5,714) 
and the income levels at which the phase-out of the credit begins 
($6,500 in 1987 and $9,000 in 1988 and later years) are to be adjust- 
ed, beginning in 1987, for inflation occurring after 1984. These ad- 
justments will not be subject to the $50 rounding-down rule other- 
wise applicable under the conference agreement to inflation adjust- 
ments. 

Under the conference agreement, Treasury regulations are to re- 
quire employers to notify employees whose wages are not subject to 
income tax withholding that they may be eligible for the refund- 
able earned income credit. 

C. Exclusions From Income 

1. Unemployment compensation benefits 

The present-law partial exclusion for unemployment compensa- 
tion benefits is repealed, effective beginning in 1987. 

2. Scholarships and fellowships 

Under the conference agreement, the exclusion for scholarship or 
fellowship grants is limited to degree candidates, and to amounts 
required to be used for tuition and course-required fees, books, sup- 
plies, and equipment; thus, additional amounts for room, board, or 
incidental expenses are not excludable. No exclusion is provided for 
nondegree candidates. 

The conference agreement also provides that the exclusion does 
not apply to any portion of amounts received as a grant or a tui- 
tion reduction that represents payment for teaching, research, or 
other services required as a condition of receiving the grant, or to 
certain Federal grants where the recipient is required to perform 
future services as a Federal employee. 

These provisions are effective for scholarships and fellowships 
granted after August 16, 1986. 

S. Prizes and awards 

Under the conference agreement, the present-law exclusion for 
certain prizes and awards for charitable, scientific, artistic, and 
similar achievements is to apply only if the winner assigns the 
prize or award to charity. The conference agreement provides a 
limited exclusion for certain employee awards for length of service 
or safety achievement; all other prizes or awards by employers to 
employees are includible in income except for de minimis fringe 
benefits excludable under Code section 132(e). These provisions are 
effective beginning in 1987. 



D. Deductions for Personal Expenditures 

1. Itemized deduction for State and local sales taxes 

The itemized deduction for State and local sales taxes is re- 
pealed, effective beginning in 1987. The itemized deductions for 
State and local income taxes, real estate taxes, and personal prop- 
erty taxes are retained. 

The conference agreement also provides that State, local, and 
foreign taxes for which an itemized deduction is not allowed, but 
which are incurred in a business or investment activity in connec- 
tion with the acquisition or disposition of property, are not deducti- 
ble; instead, such taxes are to be treated as part of the cost of the 
acquired property or as a reduction in the amount realized on the 
disposition. This provision is effective for taxable years beginning 
on or after January 1, 1987. 

2. Charitable deduction for nonitemizers 

Under the conference agreement, the nonitemizer charitable de- 
duction terminates for contributions made after December 31, 1986, 
as under present law. 

S. Medical expense deduction 

The floor under the medical expense deduction is increased from 
five percent to 7.5 percent of the taxpayer's adjusted gross income, 
effective beginning in 1987. The conference agreement clarifies 
that certain expenses incurred to accommodate a personal resi- 
dence to the needs of a physically handicapped individual are eligi- 
ble for the medical expense deduction. 

4- Adoption expenses 

The itemized deduction for certain costs of adopting special needs 
children is repealed, effective beginning in 1987. Also, the confer- 
ence agreement modifies the Adoption Assistance Program of Title 
IV-E of the Social Security Act to provide assistance through that 
program for such adoption expenses. 

5. Deductibility of mortgage interest and taxes allocable to 
certain housing allowances 

The conference agreement provides that the receipt of tax-free 
housing allowances by ministers or military personnel does not 
result in loss of deductions for mortgage interest or real property 
taxes on the individual's residence, effective for past and future 
years. 

E. Expenses for Business or Investment 

1. Meals, travel, and entertainment expenses 

Under the conference agreement, 80 percent of otherwise allow- 
able business meal expenses and business entertainment expenses 
are deductible, subject to certain exceptions (including qualified 
banquet meeting meals) allowing full deductibility. The require- 
ments for deducting business meal expenses are tightened, general- 
ly by conformity to the standards for deducting other business en- 
tertainment expenses. 



No deductions are allowed for (1) any costs of attending conven- 
tions or seminars other than for trade or business purposes, (2) edu- 
cational travel expenses, (3) charitable travel expenses unless there 
is no significant element of personal pleasure, recreation, or vaca- 
tion in the travel, or (4) costs (other than 80 percent of regular 
ticket costs) of renting skyboxes for more than one event (subject to 
a three-year phase-in of skybox nondeductibility). Deductions for 
entertainment ticket costs and luxury water travel are limited. The 
conference agreement also tightens certain rules with respect to 
home office expenses and hobby losses. 

These provisions are effective for taxable years beginning on or 
after January 1, 1987. 

2. Employee business expenses, investment expenses, and other 
miscellaneous itemized deductions 

Under the conference agreement, employee business expenses 
other than reimbursed expenses (sec. 62(2)(A)) are to be allowed 
only as itemized deductions and are subject to the floor described 
below. Moving expenses of an employee or self-employed individual 
are to be allowed only as itemized deductions, but are not subject 
to the new floor. 

The miscellaneous itemized deductions, including the employee 
business expenses described above, generally are subject to a floor 
of two percent of the taxpayer's adjusted gross income. However, 
the floor does not apply to impairment-related work expenses for 
handicapped employees; estate tax in the case of income in respect, 
to a decedent; certain adjustments where a taxpayer restores! 
amounts held under a claim of right; amortizable bond premium; 
certain costs of cooperative housing corporations; expenses of short 
sales in the nature of interest; certain terminated annuity pay- 
ments; and gambling losses to the extent of gambling winnings. 
The floor is to apply with respect to indirect deductions through 
pass-through entities (including mutual funds) other than estates, 
trusts, cooperatives, and REITs. 

Under the conference agreement, a new above-the-line deduction 
is allowed for business expenses of certain performing artists who 
had more than one employer during the taxable year, whose allow- 
able expenses in performing such services exceed 10 percent of 
wages for such services, and whose adjusted gross income (before 
deducting such expenses) does not exceed $16,000. 

These provisions are effective for taxable years beginning on or 
after January 1, 1987. 

F. Political Contributions Tax Credit 

The conference agreement repeals the tax credit for political con- 
tributions, effective beginning in 1987. 



Title II. Capital Cost Provisions 
A. Cost Recovery: Depreciation; ITC; Finance Leases 

1. Depreciation and expensing 
Accelerated Cost Recovery System 

The conference agreement modifies the Accelerated Cost Recov- 
ery System (ACRS) for property placed in service after December 
31, 1986, except for property covered by transition rules. The cost 
of property placed in service after July 31, 1986, which is not tran- 
sition-rule property, may be covered under the modified rules at 
the election of the taxpayer. 

The conference agreement provides more accelerated deprecia- 
tion for the revised three-year, five-year, and ten-year classes and 
reclassifies certain assets according to their present class life (or 
"ADR midpoint life"), including the creation of a seven-year and 
twenty-year class. Depreciation methods are prescribed for each 
ACRS class (in lieu of providing statutory tables). Eligible personal 
property is assigned among a three-year class, a five-year class, a 
seven-year class, a ten-year class, a fifteen-year class, or a twenty- 
year class. 

The depreciation method applicable to property included in the 
three-year, five-year, seven-year, and ten-year classes is the double 
declining balance method, switching to the straight-line method at 
a time to maximize the depreciation allowance. For property in the 
fifteen-year and twenty-year cl£iss, the conference agreement ap- 
plies the 150-percent declining balance method, switching to the 
straight-line method at a time to maximize the depreciation allow- 
ance. The cost of real property is recovered using the straight-line 
method over 27.5 years for residential rental property and 31.5 
years for nonresidential real property. 

Property is classified into the classes as follows: 

Three-year class. — ADR midpoints of four years and less, except 
excludes automobiles and light trucks, and includes horses in the 
present-law three-year class. 

Five-year class. — ADR midpoints of more than four years and less 
than 10 years, and adding automobiles, light trucks, qualified tech- 
nological equipment, computer-based central office switching equip- 
ment, renewable energy and biomass properties that are small 
power production facilities, and research and experimentation 
property. 

Seven-year class. — ADR midpoints of 10 years and more and less 
than 16 years, adding single-purpose agricultural or horticultural 
structures and property with no ADR midpoint not classified else- 
where. 

Ten-year class. — ADR midpoints of 16 years and more and less 
than 20 years. 

(7) 



8 

Fifteen-year class. — ADR midpoints of 20 years and more and less 
than 25 years, including waste-water treatment plants, and tele- 
phone distribution plant and comparable equipment used for the 
two-way exchange of voice and data communications. 

Twenty-year class. — ADR midpoints of 25 years and more, other 
than real property with an ADR midpoint of 27.5 years and more, 
and including sewer pipes. 

27.5-year class. — Residential rental property. 

31.5-year class. — Nonresidential real property (real property that 
is not residential rental property and that either has no ADR mid- 
point, or the ADR midpoint of which is not less than 27.5 years). 

Alternative Depreciation System 

A taxpayer may elect to recover the cost of property over the 
ACRS class life or, generally, the ADR midpoint life, using the 
straight-line method. For purposes of computing the depreciation 
preference under the minimum tax, the cost of personal property is 
recovered using the 150-percent declining balance method, switch- 
ing to the straight-line method, generally over the ADR midpoint 
life. Additionally, assets used abroad or by tax-exempt entities, or 
financed with the proceeds of tax-exempt bonds, and for purposes 
of computing earnings and profits must be recovered using the 
straight-line method generally over the ADR midpoint life. 

Expensing 

The amount of personal property that may be expensed is in- 
creased to $10,000 (from the present-law $5000). For every dollar of 
qualifying investment in excess of $200,000, the $10,000 limit is re- 
duced by one dollar. 

2. Regular investment tax credit 

The conference agreement repeals the investment tax credit for 
property placed in service after December 31, 1985, except for prop- 
erty covered by transition rules. Investment tax credits on transi- 
tion property result in a full basis adjustment. Beginning in 1988, 
credits on transition property and credit carryovers are subject to a 
35-percent reduction (17.5 percent in 1987). 

S. Finance leasing 

Finance leasing is repealed for agreements entered into after De- 
cember 31, 1986, except for property covered by transition rules. 

B. Limit on General Business Credit 

The conference agreement reduces the 85-percent limitation on 
the amount of income tax liability that can be offset by business 
tax credits to 75 percent, for taxable years beginning after Decem- 
ber 31, 1985. Credits subject to the limitation include the research 
credit and the low-income housing credit. 

C. Research and Development 

1. Tax credit for increasing research expenditures 

The conference agreement extends the incremental research tax 
credit for an additional three years, i.e., for qualified research ex- 



penditures paid or incurred through December 31, 1988. In addi- 
tion, the conference agreement modifies the credit as follows: 

(a) The credit rate is reduced from 25 percent to 20 percent. 

(b) Rental and similar payments for the use of personal property 
in research are made ineligible for the credit, except for certain 
payments for use of computer time. 

(c) The definition of qualified research for purposes of the credit 
is modified. 

(d) Increased tax incentives are provided for corporate cash ex- 
penditures in excess of certain floors for basic research performed 
by universities or certain scientific research organizations. 

(e) The general limitation on use of business credits is applied to 
the research credit. 

The provision extending the research credit is effective for tax- 
able years ending after December 31, 1985, with respect to expendi- 
tures prior to January 1, 1989. The provisions modifying the credit 
are effective for taxable years beginning after December 31, 1985, 
except that the modifications to the university basic research credit 
are effective for taxable years beginning after December 31, 1986. 

2. Augmented charitable deduction for donations of scientific 

equipment 

The present-law rule allowing an augmented charitable deduc- 
tion for donations of newly manufactured scientific equipment to 
universities for research use is extended to such donations made to 
certain tax-exempt scientific research organizations, effective for 
taxable years beginning after December 31, 1985. 

3. Tax credit for orphan drug clinical testing 

The tax credit for clinical testing of orphan drugs is extended for 
three additional years, i.e., through December 31, 1990. 

D. Rapid Amortization Provisions 

1. Trademark and trade name expenditures 

The conference agreement repeals five-year amortization for 
trademarks and tradenames, for expenditures paid or incurred 
after December 31, 1986. Transitional rules are provided for certain 
binding contracts. 

2. Railroad grading and tunnel bores 

The conference agreement repeals 50-year amortization for quali- 
fied railroad grading and tunnel bores, for expenditures paid or in- 
curred after December 31, 1986. Transitional rules are provided for 
certain binding contracts. 

3. Bus operating authorities 

Owners of certain bus operating authorities are allowed an ordi- 
nary deduction ratably over five years for loss in value of such au- 
thorities, effective for taxable years ending after November 18, 
1982. A similar rule will apply to freight forwarders, contingent on 
deregulation. 



10 

J^. Removal of architectural and transportation barriers to the 
handicapped and elderly 

The conference agreement makes permanent the election to 
deduct up to $35,000 of quahfying expenditures for removing archi- 
tectural and transportation barriers to the handicapped and elder- 
ly, effective for taxable years beginning after December 31, 1985. 

E. Real Estate Provisions 

1. Tax credit for rehabilitation expenditures 

The conference agreement replaces the existing three-tier reha- 
bilitation credit with a two-tier credit for qualified rehabilitation 
expenditures. The credit percentage is 10 percent for expenditures 
incurred in rehabilitation of buildings (other than certified historic 
structures) built before 1936, and 20 percent for certified historic 
structures. 

In general, the conference agreement retains the structure of the 
existing rehabilitation credit, except that the external walls re- 
quirement is modified in the case of certified historic structures. In 
addition, the conference agreement requires a basis adjustment for 
the full amount of the rehabilitation credit in the case of both his- 
toric and nonhistone buildings. 

For a summary of the rules applicable with respect to the credit 
under the passive loss limitations of the conference agreement, see 
Title V.B., below. 

The modifications to the rehabilitation credit generally are appli- 
cable to property placed in service after December 31, 1986. 

2. Tax credit for low-income rental housing 

The conference agreement provides a new t£ix credit that may be 
claimed by owners of residential rental property providing low- 
income housing. This new tax credit replaces existing tax incen- 
tives for low-income housing — i.e., preferential depreciation, five- 
year amortization of rehabilitation expenditures, and special treat- 
ment of construction period interest and taxes. Separate credits are 
provided for new construction and rehabilitation of low-income 
housing and for certain costs of acquisition of existing housing to 
serve low-income individuals. 

The credits are claimed annually for a period of 10 years. The 
annual credit has a maximum rate for property placed in service in 
1987 of nine percent for new construction and rehabilitation, and a 
maximum rate of four percent for the acquisition cost of existing 
housing. (These credit rates are equivalent to a credit with a 
present value of 70 percent and 30 percent, respectively.) All cred- 
its apply only to the expenditures on the low-income units. In addi- 
tion, in order to qualify for the credit for new construction or reha- 
bilitation, such expenditures must exceed $2,000 per low-income 
unit. Certain costs of new construction and rehabilitation of low- 
income housing financed with tax-exempt bonds or receiving other 
Federal subsidies are eligible for a credit having a present value of 
30 percent (i.e., for property placed in service in 1987, four percent 
each year for 10 years). 

Residential rental property is eligible for the credit if either (1) 
at least 20 percent of the housing units in the project are occupied 



11 

by individuals with incomes of 50 percent or less of area median 
income, or (2) at least 40 percent of the housing units in the project 
are occupied by individuals with incomes of 60 percent or less of 
area median income. Income limits are adjusted for family size and 
may be adjusted for areas with unusually low family income or 
high housing costs relative to family income. The rent charged to 
tenants in units with respect to which the credit is allowable may 
not exceed 30 percent of the qualifying income. Eligible projects 
must continuously comply with these requirements for a 15-year 
period. The penalty for noncompliance is recapture of prior credits. 
Certain si'-gle room occupancy housing is eligible for the credit. 

Each State is permitted to issue low-income rental housing tax 
credits in an annual amount equal to $1.25 per resident of the 
State. At least 10 percent of this credit authority must be reserved 
for projects developed by certain nonprofit organizations, one of 
whose exempt purposes is the fostering of low-income housing. This 
credit authority is sufficient to cover approximately $14 per capita 
of new construction or rehabilitation expenditures (for property not 
receiving other Federal subsidies) or $31 per capita of acquisition 
cost. Additionally, expenditures financed with the proceeds of tax- 
exempt bonds are eligible for the credit without reducing a State's 
credit authority, since the volume of these bonds is directly limited 
under the conference agreement. 

The basis with respect to which credits are allowed must be re- 
duced by the amount of any rehabilitation credit under section 46 
for which the property is eligible. The basis of a project for depre- 
ciation is not reduced by the amount of low-income housing tax 
credits claimed. 

For a summary of the rules applicable with respect to the credit 
under the passive loss limitations of the conference agreement, see 
Title V.B., below. For purposes of the credit, a limited exception to 
the credit at-risk rules is provided. 

The credit is effective for property placed in service after Decem- 
ber 31, 1986, and before January 1, 1990. Property placed in service 
after 1989 may qualify for the credit if expenditures of 10 percent 
or more of total project costs are incurred before January 1, 1989, 
and the property is placed in service before January 1, 1991. 

F. Merchant Marine Capital Construction Fund 

The Merchant Marine Act of 1936, as amended, provides Federal 
income tax incentives for U.S. taxpayers who own or lease vessels 
operated in the foreign or domestic commerce of the United States 
or in U.S. fisheries. The conference agreement coordinates the ap- 
plication of the Internal Revenue Code of 1986 with the capital con- 
struction fund program of the Merchant Marine Act of 1936, as 
amended. In addition, new requirements are imposed relating to (1) 
the tax treatment of nonqualified withdrawals, (2) certain reports 
to be made to the Secretary of the Treasury by the Secretaries of 
Transportation and Commerce, and (3) a 25-year time limit on the 
amount of time monies can remain in a fund without being with- 
drawn for a qualified purpose, effective for taxable years beginning 
after December 31, 1986. 



Title III. Capital Gains and Losses 

A. Individual Capital Gains 

The conference agreement repeals the present-law exclusion for 
long-term capital gains of individuals, effective for t£ixable years 
beginning on or after January 1, 1987. Thus, such gains will be 
taxed at the same rates as ordinary income. However, the tax rate 
on long-term capital gains during calendar year 1987 will not 
exceed 28 percent. Capital losses are allowed in full against capital 
gains plus $3,000 of other income. 

The present-law rules for nonrecognition of gain on sale of a 
principal residence where reinvested in a new residence, and for a 
one-time exclusion of up to $125,000 of gain on sale of a principal 
residence by a taxpayer age 55 or older, are retained. 

B. Corporate Capital Gains 

The alternative tax rate for net capital gains of corporations 
shall not apply for gain included in income in taxable years when 
the new corporate rates are fully effective (i.e., years beginning on 
or after July 1, 1987). For gain included in income in earlier tax- 
able years but after December 31, 1986, the alternative t£ix rate is 
34 percent. As under present law, capital losses are allowed in full 
against capital gains. 

C. Incentive Stock Options 

The conference agreement liberalizes the incentive stock option 
provisions by repealing the requirement that options must be exer- 
cised in the order granted, and modifies the $100,000 limit on the 
amount of options that may be granted in any year. Under this 
modification, an employer may not, in the aggregate, grant an em- 
ployee incentive stock options that are first exercisable during any 
one calendar year to the extent that the aggregate fair market 
value of the stock (at the time the options are granted) exceeds 
$100,000. These provisions apply to options granted after December 
31, 1986. 

D. Straddles 

Under the loss deferral rule in the straddle provisions, the con- 
ference agreement denies the qualified covered call exception to a 
taxpayer who fails to hold an option for 30 days after the related 
stock is disposed of at a loss, where gain on termination or other 
disposition of the option is included in the subsequent year. This 
provision applies to positions established after December 31, 1986. 



(12) 



Title IV. Agriculture, Timber, Energy, and Natural Resources 
A. Agricultural Provisions 

1. Special expensing provisions 

The conference agreement provides that soil and water conserva- 
tion expenditures are deductible only if they relate to improve- 
ments that are consistent with a conservation plan approved by the 
the U.S. Department of Agriculture or, if there is no Federally ap- 
proved plan in the location of the land on which improvements are 
made, by a comparable State agency. In no event, however, may ex- 
penditures relating to the draining or filling of wetlands or the in- 
stallation or operation of a center pivot irrigation system be de- 
ducted under this provision. This provision applies to expenditures 
after December 31, 1986. 

The special provision allowing a deduction for land clearing ex- 
penditures is repealed, effective for expenditures after December 
31, 1985. The special election to expense fertilizer and soil condi- 
tioning expenditures is retained. 

2. Dispositions of converted wetlands and highly erodible 

croplands 

The conference agreement provides that gain from the disposi- 
tion of wetlands and highly erodible cropland that are converted to 
agricultural use (other than livestock grazing) is ordinary and that 
any loss on such disposition is a capital loss. The provision is effec- 
tive for dispositions of land converted after March 1, 1986. 

S. Preproductive period expenses of farmers 

In general. — The conference agreement provides that the uniform 
capitalization rules (see VIII. D., below) apply to farmers in the case 
of products having a preproductive period of more than two years. 
Under a special election, certain farmers may elect to deduct pre- 
productive period expenses currently, provided the alternative cost 
recovery system is used on all farm assets. The provision is effec- 
tive for taxable years beginning after December 31, 1986. 

Grove, orchard, and vineyard crops. — The conference gigreement 
provides that planting and maintenance costs incurred following 
loss or damage to a grove, orchard, or vineyard as a result of freez- 
ing temperatures, disease, drought, pests, or casualty may be de- 
ducted by persons other than the farmer who owned the grove, etc., 
at the time the damage occurred, provided that (1) the taxpayer 
who owned the property at such time retains an equity interest of 
more than 50 percent in the property, and (2) the person claiming 
the deduction owns part of the remaining equity interest and mate- 
rially participates in the planting or maintenance of the property. 
In addition, replanting costs may qualify even though the grove, 
etc. is replanted in a different location, provided the costs do not 

(13) 



14 

relate to acreage in excess of the acreage of the property on which 
the loss or damage occurred. This provision is effective for such 
costs paid or incurred after the date of enactment. 

4. Prepayments of farming expenses 

The conference agreement provides that to the extent the pre- 
paid farming expenses of a farmer using the cash method of ac- 
counting exceed 50 percent of total nonprepaid farm expenses, 
amounts paid for feed, seed, fertilizer, and certain other similar 
farm items may be deducted only as such items are actually con- 
sumed. This provision applies to amounts with respect to which a 
deduction otherwise would be allowable under present law after 
March 1, 1986. 

5. Treatment of discharge of indebtedness income for certain 

farmers 

The conference agreement provides that discharge of indebted- 
ness income arising from an agreement between a solvent individ- 
ual debtor engaged in the trade or business of farming and an un- 
related person to discharge certain farming indebtedness is treated 
as income realized by an insolvent individual, and hence is eligible 
for exclusion from income if certain conditions are satisfied. Quali- 
fied indebtedness includes debt incurred to finance production of 
agricultural products and business debt secured by farmland or 
equipment. The provision applies to discharge of indebtedness 
income realized after the date of enactment. 

B. Timber Provisions 

1. Preproductive expenses of growing timber 

The conference agreement retains present law treatment with 
regard to the preproductive expenses of growing timber. 

2. Reforestation expenses 

The conference agreement retains present law treatment, allow- 
ing up to $10,000 of reforestation expenditures incurred in each 
taxable year to qualify for amortization over a seven-year period, 
and also a 10-percent tax credit. 

3. Capital gains for timber 

The capital gains rate for timber is conformed to the top individ- 
ual and corporate tax rates, effective in accordance with the gener- 
al amendments to the treatment of individual and corporate cap- 
ital gains. Taxpayers are permitted to revoke elections (under sec. 
631(a)) to treat cutting of timber as a sale or exchange. 

C. Oil, Gas, and Geothermal Properties 

1. Intangible drilling costs 

The conference agreement generally retains the present-law tax 
treatment of domestic IDCs, but increases to 30 percent the 
present-law reduction in expensible IDCs of integrated producers. 
This 30-percent amount must be amortized over a five-year, 
straight-line period. 



15 

IDCs incurred on wells located outside the United States (other 
than nonproductive wells) are to be recovered (i) using 10-year, 
straight-line amortization, or (ii) at the taxpayer's election, as part 
of the basis for cost depletion. 

These provisions are generally effective for costs paid or incurred 
after December 31, 1986. 

2. Percentage depletion for bonuses and advance royalties 

The conference agreement denies percentage depletion for lease 
bonuses, advance royalties, or any other amount payable without 
regard to actual production from an oil, gas, or geothermal proper- 
ty. This reverses the holding in Commissioner v. Engle, 464 U.S. 
206 (1984). 

D. Hard Minerals 

1. Exploration and development costs 

The conference agreement generally retains the present-law 
treatment of domestic mining exploration and development costs. 
However, the reduction in expensible exploration and development 
costs for corporations (under sec. 291) is increased to 30 percent. 
This 30-percent amount is required to be amortized over a five- 
year, straight-line period. 

In the case of foreign mines, exploration and development costs 
are recovered by (1) 10-year straight-line amortization or (2) at the 
election of the taxpayer, as part of the basis for cost depletion. 

These provisions are effective for costs paid or incurred after De- 
cember 31, 1986. 

2. Percentage depletion of hard mineral deposits 

The conference agreement increases the reduction in corporate 
coal and iron ore percentage depletion deductions (under sec. 291) 
from 15 to 20 percent, effective for taxable years beginning after 
December 31, 1986. Present-law depletion rates are retained for 
hard minerals. 

3. Gain on disposition of interest in mineral properties 

The conference agreement expands the amount of gain that must 
be treated as ordinary income on the disposition of oil, gas, or geo- 
thermal property to include the amount of depletion deductions 
that have previously reduced basis, in addition to intangible drill- 
ing costs. Similar rules are applied for mining exploration and de- 
velopment costs. The new provisions generally apply to property 
placed in service by the taxpayer after 1986. 

E. Energy-Related Tax Credits and Other Incentives 

1. Business energy tax credits 

The solar energy tax credit is extended for three years at 15 per- 
cent in 1986, 12 percent in 1987, and 10 percent in 1988. 

The geothermal energy tax credit is extended for three years at 
15 percent in 1986, and 10 percent in 1987 and 1988. 

The conference agreement does not extend to dual purpose solar 
or geothermal energy property. The conference committee, howev- 



16 

er, notes with respect to this matter that there are administrative 
issues which the Treasury Department should resolve under the 
regulatory authority provided in the Energy Tax Act of 1978 and 
subsequent Acts with provisions relating to energy tax credits. 

The ocean thermal energy tax credit is extended for three years 
at 15 percent. 

The biomass energy tax credit is extended for two years at 15 
percent in 1986 and 10 percent in 1987. 

Energy tax credits earned under the affirmative commitment 
rules will be treated in the same manner as the general investment 
tax credit for transition property. 

2. Alcohol fuels 

The conference agreement generally incorporates the language of 
section 864 of H.R. 4800, which permits duty-free entry of (1) ethyl 
alcohol which has been both fermented and dehydrated in an insu- 
lar possession or a CBI country, or (2) ethyl alcohol dehydrated in 
an insular possession or CBI country produced using hydrous ethyl 
alcohol which is wholly the product of manufacture of any insular 
possession or beneficiary country having a value not less than 30 
percent in 1987, 60 percent in 1988, and 75 percent thereafter of 
the value of the ethyl alcohol or mixture. 

Ethyl alcohol imported for other than fuel uses is excluded from 
tariff through a certification process with evidence of actual use 
presented within a reasonable time. The definition of ethyl alcohol 
is clarified to include mixtures containing ethyl alcohol which are 
suitable for use as fuel or in producing a fuel. 

These provisions apply to articles entered after December 31, 
1986, subject to certain transition provisions. 

3. Neat alcohol fuels 

The nine-cents-per-gallon exemption from the motor fuels excise 
tax for neat alcohol fuels (methanol and ethanol) is reduced to six- 
cents per-gallon after December 31, 1986. 

4' Taxicab fuels tax exemption 

The four-cents-per-gallon excise tax exemption from the motor 
fuels excise taxes for taxicabs meeting specified requirements is ex- 
tended from October 1, 1985, through September 30, 1988. 



Title V. Tax Shelters; Interest Expense 

A. At-Risk Rules 

The at-risk rules are extended to the activity of holding real 
property, with an exception for qualified nonrecourse financing 
which is secured by real property used in the activity. Under this 
rule, real estate joint ventures may obtain financing from an other- 
wise qualified lender who has an equity interest in the venture, 
provided that the terms of financing are commercially reasonable 
and substantially similar to loans made to unrelated parties. Seller 
financing is not treated as qualified nonrecourse financing. 

This provision is effective with respect to property acquired after 
December 31, 1986. 

B. Limitations on Losses and Credits from Passive Activities 

Deductions from passive activities, to the extent that they exceed 
income from all such activities (exclusive of portfolio income), gen- 
erally may not be deducted against other income of the taxpayer. 
Similarly, credits from passive activities generally are limited to 
the tax allocable to the passive activities. Suspended losses and 
credits are carried forward and treated as deductions and credits 
from passive activities in the next taxable year. When the taxpayer 
disposes of his entire interest in an activity, any remaining sus- 
pended loss incurred in connection with that activity is allowed in 
full. 

Passive activities are defined to include trade or business activi- 
ties in which the taxpayer does not materially participate (e.g., a 
limited partnership interest in an activity), and rental activities. 
Passive activities do not include working interests in oil and gas 
property in which the taxpayer's form of ownership does not limit 
liability. Interest attributable to passive activities is not treated as 
investment interest (see C, below). 

In the case of rental real estate activities in which an individual 
actively participates, up to $25,000 of losses (and credits, in a de- 
duction-equivalent sense) from all such activities may be taken in 
each year against non-passive income of the taxpayer. This amount 
is phased out ratably between $100,000 and $150,000 of adjusted 
gross income (determined without regard to passive losses). 

The rehabilitation and low income housing credits (but not losses 
from such activities except to the extent stated above) may be used 
to offset tax on up to $25,000 of non-passive income regardless of 
whether the taxpayer actively participates, subject to a phaseout 
between $200,000 and $250,000 of adjusted gross income (disregard- 
ing passive losses). The exceptions under the passive loss rule for 
the low income housing credit apply only (for the original credit 
compliance period) to property placed in service before 1990, except 

(17) 



18 

if the property is placed in service before 1991 and 10 percent or 
more of the total project costs are incurred before 1989. 

The provision generally applies to individuals, estates, trusts, 
and personal service corporations (as defined for purposes of the 
provision). Certain closely held corporations are subject to a more 
limited rule under which passive losses and credits may not be ap- 
plied to offset portfolio income. 

The provision is effective for taxable years beginning after De- 
cember 31, 1986, but is phased in over five years for interests in 
passive activities in which the taxpayer invested prior to the date 
of enactment. During the phase-in period, the amount of excess 
losses and credits from such activities that are disallowed is limited 
to 35 percent in taxable years beginning in 1987, 60 percent in tax- 
able years beginning in 1988, 80 percent in taxable years beginning 
in 1989, 90 percent in taxable years beginning in 1990, and. 100 per- 
cent in taxable years beginning in 1991 and thereafter. Any passive 
loss which is disallowed for a taxable year during the phase-in 
period and carried forward may be allowed in a subsequent year 
only to the extent there is net passive income in the subsequent 
year (or the activity is disposed of). 

C. Interest Deduction Limitation 

No deduction is allowed for personal interest (such as interest on 
car loans or credit card balances for personal expenditures). Inter- 
est on underpajonents of tsix (other than certain deferred estate 
taxes) is treated as personal interest under the provision. Interest 
on debt secured by the principal residence or a second residence of 
the taxpayer is deductible only to the extent the amount of the 
debt does not exceed the purchase price of the residence plus the 
cost of improvements, except that home mortgage interest on debt 
in excess of the purchase price plus improvements, up to the fair 
market value of the residence, is deductible if the debt is incurred 
for educational or medical purposes. 

The deduction for investment interest is generally limited to the 
amount of net investment income. Interest (and income) from ac- 
tivities subject to the passive loss rules is not treated as investment 
interest (or investment income). In calculating net investment 
income, passive losses that are allowed under the passive loss 
phase-in provision are subtracted from investment income. 

The provision is effective for taxable years beginning after De- 
cember 31, 1986 but is phased in. During the phase-in period, the 
amount of interest disallowed under the provision is limited to 35 
percent in taxable years beginning in 1987, 60 percent in taxable 
years beginning in 1988, 80 percent in taxable years beginning in 
1989, 90 percent in taxable years beginning in 1990, and 100 per- 
cent in taxable years beginning in 1991 and thereafter. Interest 
that is disallowed for a taxable year during the phase-in period and 
carried forward may be allowed in a subsequent year only to the 
extent there is investment income in excess of net investment in- 
terest paid or incurred in such subsequent year. 



Title VI. Corporate Taxation 

A. Corporate Tax Rates 

The conference agreement provides a three-bracket graduated 
corporate rate structure as follows: 

Taxable income: Tax rate 

Not over $50,000 15% 

Over $50,000 but not over $75,000 25% 

Over $75,000 34% 



This structure reduces from five to three the number of corpo- 
rate income tax brackets, and lowers from 46 to 34 the tax rate ap- 
plicable to large corporations. The benefit of graduated rates is 
fully phased out for corporations with more than $335,000 of tax- 
able income (compared to $1,405,000 under present law). 

The graduated income tax rates are effective for taxable years 
beginning on or after July 1, 1987. For taxable years including July 
1, 1987, blended rates will apply. 

(See Title III.B., above, regarding corporate long-term capital 
gains.) 

B. Corporate Dividends Paid Deduction 

The conference agreement does not adopt the House bill provi- 
sion, which would have provided a new 10-percent dividends paid 
deduction phased in over 10 years. 

C. Corporate Dividends Received Deduction 

The 85-percent dividends received deduction under present law is 
reduced to 80 percent for dividends received after December 31, 
1986. 

D. Extraordinary Dividends 

The conference agreement requires the basis of stock held by a 
corporation to be reduced by the untaxed portion of extraordinary 
dividends, if the stock has not been held for at least two years 
before the date of announcement or agreement about the dividend, 
with provisions for certain joint venture agreements and preferred 
stock dividends. For purposes of determining whether a dividend is 
extraordinary under the two-year rule, a taxpayer may measure 
the dividend by reference to the market value of the stock rather 
than its basis, provided market value is established to the satisfac- 
tion of the IRS. Certain other distributions are also treated as ex- 
traordinary dividends requiring basis adjustments. 

(19) 



63-115 - 86 



20 

The two-year provision applies to dividends announced after July 
18, 1986; other modifications apply to dividends declared after date 
of enactment. 

E. Dividend Exclusion for Individuals 

The $100 dividend exclusion for individuals ($200 for a joint 
return) is repealed, effective for taxable years beginning after De- 
cember 31, 1986. 

F. Stock Redemption Payments 

The conference agreement provides that no amount paid or in- 
curred by a corporation in connection with a redemption of its 
stock is deductible or amortizable. This would preclude, for exam- 
ple, deduction of so-called "greenmail" payments made to stock- 
holders to avert a hostile takeover. The provision is effective for 
amounts paid or incurred after February 28, 1986. 

G. Limitations on Net Operating Loss (NOL) Carryovers 

The conference agreement modifies the special limitations on the 
use of net operating loss (NOL) and other carryforwards. 

After a change in ownership of more than 50 percent of value of 
stock in a loss corporation, however effected, the taxable income 
available for offset by pre-ownership change NOLs is limited to the 
long-term tax-exempt rate for the ownership change date, times 
the value of the loss corporation's equity. In addition, NOL carry 
forwards are disallowed unless the loss corporation satisfies the 
continuity-of-business-enterprise rule that applies to tax-free reor- 
ganizations for the two-year period following an ownership change, 
regardless of the type of transaction that results in the change of 
control. The conference agreement also expands the scope of the 
special limitations to include built-in losses (other than deprecia- 
tion) and takes into account built-in gains. 

In certain circumstances, creditors who exchange debt for stock 
in a bankruptcy are treated as continuing shareholders with a pro- 
vision for reducing NOLs by interest deductions taken with respect 
to exchanged debt within three years prior to the exchange. How- 
ever, NOLs are reduced by 50 percent of the excess of the dis- 
charged debt over the value of the stock transferred to the credi- 
tors, and there are restrictions on subsequent ownership changes 
within two years. 

The conference agreement includes a number of rules designed 
to ensure the limitations accomplish their intended objectives and 
makes other changes to present law, of a more technical nature, 
including rules relating to the measurement of beneficial owner- 
ship. Similar rules are applied to carryforwards other than NOLs, 
such as net capital losses and excess foreign tax credits, as well as 
passive activity losses and credits and minimum tax credits under 
the conference agreement. 

In general, the provisions apply to changes in ownership that 
occur after December 31, 1986 (unless pursuant to plans of tax-free 
reorganization adopted before January 1, 1987, or petitions filed in 
bankruptcy court before August 14, 1986). 



21 

H. Gain or Loss on Liquidating Sales and Distributions 

The conference agreement provides that, in general, gain or loss 
is recognized to a corporation on a distribution of its property in 
complete liquidation, as if it had sold the property at fair market 
value. This repeals the so-called General Utilities rule. An excep- 
tion is provided for carryover basis distributions to certain control- 
ling corporate shareholders. There is no general exception for dis- 
tributions to noncorporate, long-term shareholders; however, there 
is additional transition relief for certain small, closely held compa- 
nies. 

The provision generally applies to liquidations completed after 
December 31, 1986 (including deemed liquidations under section 338 
where the acquisition date is after December 31, 1986). However, 
liquidations completed before January 1, 1988 (including deemed 
liquidations under section 338 where the acquisition date is before 
1988) are grandfathered if pursuant to a plan of liquidation adopt- 
ed before August 1, 1986 or a binding contract for sale of the com- 
pany entered into before August 1, 1986. Liquidations grandfa- 
thered under the special definitions of the House bill as to what 
constituted adequate action before November 20, 1985 are also 
grandfathered if they are completed before January 1, 1988. Com- 
plete relief (except for ordinary income and short-term gain proper- 
ty) is provided for small, closely held companies on liquidations 
completed before January 1, 1989. Such companies are those not 
exceeding $5 million in value and more than 50 percent of whose 
stock is owned directly or indirectly for a substantial period by no 
more than 10 individuals. Relief phases out for such closely held 
companies with value between $5 and $10 million. 

The Treasury Department is to study reform of subchapter C and 
report to the tax-writing committees by January 1, 1988. 

/. Allocation of Purchase Price in Certain Asset Sales 

The conference agreement conforms the basis allocation rules in 
asset acquisitions to the rules for stock acquisitions where basis is 
stepped up (under section 338 rules) so that both buyer and seller 
would use the so-called "residual" method of allocating the pur- 
chase price to nondepreciable goodwill and going concern value. 
The Treasury Department is authorized to require information re- 
porting with respect to purchase price allocations. The provision 
applies to transactions after May 6, 1986, unless pursuant to a 
binding contract in effect on that date. 

/. Related Party Sales 

The conference agreement modifies the rules that limit install- 
ment sales treatment and ordinary income treatment on certain 
sales between related parties. The definition of related parties is 
expanded so that persons and entities with certain more than 50- 
percent relationships are covered (rather than the 80-percent rela- 
tionships under present law) and certain other cases are covered. 
In some cases, ratable basis recovery and conformity between 
buyer and seller regarding recognition of income and basis are re- 
quired, instead of denying deferred income treatment to the seller. 



22 

This provision applies to sales after the date of enactment, unless 
made pursuant to a binding contract in effect before August 14, 
1986. 

K. Amortizable Bond Premium 

The conference agreement requires amortizable bond premium 
deductions to be treated as interest, except as provided in regula- 
tions. 

L. Cooperative Housing Corporations 

Under the conference agreement, cooperative housing corpora- 
tions that charge tenant-stockholders with a portion of the coopera- 
tive's interest or taxes in a manner that reasonably reflects the 
cost to the cooperative of the interest or taxes allocable to each 
tenant-stockholder's dwelling unit, may elect to have such tenant- 
stockholders deduct the separately allocated amounts for income 
tax purposes (rather than amounts based on proportionate owner- 
ship of shares of the cooperative). 

In addition, under the conference agreement, the tax treatment 
of individuals owning stock in cooperative housing corporations is 
extended to corporations, trusts, and other entities that are stock- 
holders. Also, the conference agreement disallows maintenance and 
lease deductions by tenant-stockholders in situations where the 
amount paid by such tenant-stockholders is properly chargeable to 
the capital account of the cooperative. These provisions are effec- 
tive for taxable years beginning after December 31, 1986. 

M. Real Estate Investment Trusts 

The conference agreement modifies several aspects of the re- 
quirements for qualification as, and the taxation of, real estate in- 
vestment trusts (REITs). Under the conference agreement, relief is 
granted from certain shareholder and income and asset require- 
ments for the first year that an entity otherwise qualifies as a 
REIT. In addition, relief is granted from certain income and asset 
requirements for the first year after a REIT receives new equity 
capital and certain new debt capital. REITs also are permitted to 
hold assets in wholly owned subsidiaries under the conference 
agreement. 

The conference agreement modifies the definition of rents from 
real property to permit REITs to perform those services that would 
not result in the receipt of unrelated business income if performed 
by certain tax-exempt entities, without using an independent con- 
tractor. The conference agreement also includes in the definition of 
rents from real property and the definition of interest, rent, or in- 
terest that is based on the net income of the tenant or debtor, but 
only if such net income is based on amounts that would be treated 
as rents from real property if received directly by the REIT. The 
conference agreement also permits income from certain shared ap- 
preciation mortgages to be treated as qualifying income for a REIT. 

The conference agreement provides certain relief from the distri- 
bution requirement where a REIT has certain tjrpes of income that 
are not accompanied by the receipt of cash. The REIT is required 
to pay tax on amounts not distributed, however. The conference 
agreement also applies to REITs the same minimum requirement 



23 

for distribution within a taxable year applicable to regulated in- 
vestment companies. In addition, the safe harbor under which sales 
by a REIT may not be treated as prohibited transactions is expand- 
ed, the computation of the amount of capital gains dividends that a 
REIT may pay is modified, and one of the penalties relating to the 
distribution of deficiency dividends is eliminated. 

These provisions generally are effective for taxable years begin- 
ning after December 31, 1986. 

N. Mortgage-Backed Securities 

The conference agreement provides a new vehicle, referred to as 
a real estate mortgage pool (REMP) for the issuance of multiple 
class mortgage-backed securities. The REMP may be created in the 
form of a corporation, partnership or trust. The assets that the 
REMP is permitted to hold generally are limited to mortgages se- 
cured by real property. 

Under the conference agreement, the net income of the REMP is 
allocated to and taken into account by holders of "regular" and 
"residual" interests in the REMP. Amounts in excess of £Ui imput- 
ed yield on the residual interest are treated as unrelated business 
income, are subject to withholding at the statutory rate, and may 
not be offset by net operating losses (other than net operating 
losses of thrift institutions). 

The conference agreement provides rules relating to the transfer 
of mortgages to a REMP in exchange for regular or residual inter- 
ests. In addition, the conference agreement provides rules relating 
to subsequent transfers of regular and residual interests. The con- 
ference agreement also clarifies the application of the original 
issue discount and market discount rules for certain mortgage- 
backed securities. In addition, the conference agreement contains 
certain provisions which are intended to assure that only one set of 
Federal income tax consequences arises from the issuance of multi- 
ple class mortgage-backed securities. 

These provisions generally are effective for taxable years begin- 
ning after December 31, 1986. The provisions relating to other tjrpe 
of entities issuing mortgage-backed securities generally are effec- 
tive as of January 1, 1992. 

O. Regulated Investment Companies 

Under the conference agreement, regulated investment compa- 
nies (RICs) are required to distribute in each calendar year all but 
a de minimis amount of their ordinary income and all but a por- 
tion of their capital gains derived during the year. Also, RICs are 
required to pay a five-percent nondeductible excise on distributions 
to the extent that the distribution requirement for the calendar 
year is not met. 

In addition, the conference agreement provides that permitted 
income for RICs generally includes income from foreign currencies, 
and options and futures contracts, derived with respect to the RICs 
business of investing. In the case of RICs that have series funds, 
each fund is treated as a separate corporation. The time for filing 
notices for capital gains dividends and certain other purposes is ex- 
tended from 45 to 60 days. RICs are treated as third party record- 
keepers. In applying the "short-short test," certain gains from 



24 

hedging transactions are not taken into account. Business develop- 
ment companies are eligible to elect RIC status. Certain institution- 
al RICs are permitted to deduct preference dividends. 

These changes generally are effective for taxable years beginning 
after December 31, 1986. 

P. Definition of Personal Holding Company Income 

An exception from the definition of personal holding company 
income and foreign personal holding company income is provided 
for computer software royalties received by certain corporations 
that are actively engaged in the business of developing computer 
software, effective for past and future years. An exception from the 
definition of personal holding company income also is provided for 
certain interest income of a specified broker dealer in securities, ef- 
fective for interest received on or after the date of enactment. 



Title VII. Minimum Tax Provisions 

A. Individual Minimum Tax 

The present-law individual alternative minimum tax is retained 
with the following modifications. 

The minimum tax rate is increased to 21 percent. The exemption 
amount is phased out at a rate of 25 cents on the dollar for alterna- 
tive minimum taxable income in excess of $150,000 ($112,500 for 
single taxpayers and $75,000 for married taxpayers filing separate- 

ly). 

Accelerated depreciation on all property placed in service after 
1986 (other than property granted a transitional exception for regu- 
lar tax depreciation and investment tax credit purposes) is a pref- 
erence to the extent different from alternative depreciation (using 
the 150 percent declining balance method for personal property). 
The preference for intangible drilling cost deductions is reduced by 
65 percent of net oil and gas income. Tax-exempt interest on newly 
issued private activity bonuo (but not qualified 501(c)(3) bonds) and 
untaxed appreciation on charitable contributions of appreciated 
property are preferences. Use of the completed contract method of 
accounting and of the installment method are preferences. 

Certain passive farm losses are denied, and the rule limiting pas- 
sive losses for regular tax purposes applies under the minimum tax 
without a phase-in. The definition of investment interest is con 
formed to that applying for regular tax purposes, and a carryfor- 
ward is provided for disallowed interest deductions. 

Certain timing preferences (such as depreciation) are measured 
for post-1986 property on an aggregated basis, instead of item-by- 
item without netting. A credit is allowed against the regular tax 
for prior years' minimum tax liability attributable to timing prefer- 
ences. Net operating losses and foreign tax credits are not permit- 
ted to reduce the minimum tax liability that otherwise would arise 
(disregarding regular tax liability) by more than 90 percent. 

These provisions apply to taxable years beginning after Decem- 
ber 31, 1986. The treatment of interest on private activity bonds as 
a preference item applies to bonds issued after August 7, 1986, 
except that in the case of bonds covered under the Joint State- 
ments on Effective Dates of March 14, 1986, and July 17, 1986, such 
treatment applies to bonds issued on or after September 1, 1986. 

B. Corporate Minimum Tax 

An alternative minimum tax, similar to the individual minimum 
tax, replaces the present-law add-on tax. The rate is 20 percent, 
and there is a $40,000 exemption amount (phased out at the rate of 
25 cents on the dollar for alternative minimum taxable income in 
excess of $150,000). 

(25) 



26 

The items of tax preference include the corporate preferences 
under present law, accelerated depreciation (to the extent different 
from alternative depreciation, using the 150 percent declining bal- 
ance method for personal property) for all property (other than 
transitional property) placed in service after 1986, intangible drill- 
ing costs (with an offset for 65 percent of net oil and gas income), 
use of the completed contract method of accounting and of the in- 
stallment method, capital construction funds for shipping compa- 
nies, and mining exploration and development costs. Tax-exempt 
interest on newly issued private activity bonds (but not qualified 
501(c)(3) bonds), and untaxed appreciation on charitable contribu- 
tions of appreciated property are preferences. 

For 1987 through 1989, one-half of the excess of pre-tax book 
income of the taxpayer (including members of a group filing a con- 
solidated tax return for the year), over other alternative minimum 
taxable income, is a preference. After 1989, pre-tax book income is 
replaced for this purpose by earnings and profits, with certain ad- 
justments. 

Rules similar to those under the individual alternative minimum 
tax apply to incentive credits, the foreign tax credit, net operating 
losses, and the credit for minimum tax liability attributable to 
timing preferences. As a transition rule, investment tax credits 
generally are permitted to offset 25 percent of minimum tax liabil- 
ity. 

These provisions apply to taxable years beginning after Decem- 
ber 31, 1986. The treatment of interest on private activity bonds as 
a preference item applies to bonds issued after August 7, 1986, 
except that in the case of bonds covered under the Joint State- 
ments on Effective Dates (described above), such treatment applies 
to bonds issued on or after September 1, 1986. 



Title VIII. Accountinjf Provisions 

A. Limitations on the Use of the Cash Method of Accounting 

The conference agreement prohibits the use of the cash method 
of accounting by any C corporation, partnership that has a C corpo- 
ration as a partner, tax-exempt trust with unrelated business 
income, or tax shelter. Excepted entities, that may continue to use 
the cash method, are farming and timber businesses, qualified per- 
sonal service corporations, and entities (other than tax shelters) 
with average annual gross receipts of $5 million or less. 

Qualified personal service corporations are corporations that 
meet a function test and an ownership test. The function test is 
met if substantially all the activities of the corporation are the per- 
formance of services in the fields of health, law, engineering, archi- 
tecture, accounting, actuarial science, performing arts, or consult- 
ing. The ownership test is met if substantially all of the value of 
the outstanding stock of the corporation is owned by present or re- 
tired employees, the estates of such persons, by any person who ac- 
quired its ownership interest as the result of the death of such a 
person within the last 24 months, or by a holding company the 
stock of which is owned by employees of the corporation or employ- 
ees of an affiliate of the corporation that is engaged in the same 
field of service. Stock owned by an ESOP or pension plan is consid- 
ered as owned by the beneficiaries of the plan. 

The provision is effective for taxable years beginning after De- 
cember 81, 1986. Any adjustment required by the provision is to be 
taken into income over a period not to exceed four years. 

B. Simplified Dollar-Value UFO Method for Certain Small Busi- 

nesses 

The conference agreement provides an election to use a simpli- 
fied method of computing LIFO inventory values for taxpayers 
with average annual gross receipts of $5 million or less, effective 
for taxable years beginning after December 31, 198(). The method 
uses inventory pools established in accordance with general catego- 
ries of inventory items published by the Bureau of Labor Statistics. 

C. Installment Sales 

Under the conference agreement, use of the installment method 
is denied for sales pursuant to a revolving credit plan and for sales 
of certain publicly traded property. 

The conference agreement also limits the use of the installment 
method based on the ratio of the taxpayer's debt to assets for all 
sales of property held for sale to customers, and for sales of real 
property used in a trade or held for the production of rental 
income, if the selling price of such property exceeds $150,000. The 
provision does not apply, however, to installment obligations aris- 

(27) 



28 

ing from the sale of crops, livestock held for slaughter, and certain 
farm property. Personal use property, and debt related to such 
property, is not taken into account in applying the limitation. 

Taxpayers selling certain residential lots and timeshares are per- 
mitted to elect to pay interest on the deferral of tax liability attrib- 
utable to the use of the installment method, rather than be subject 
to the limitations under the conference agreement. An exception 
from the provisions of the conference agreement is provided for 
certain sales by a manufacturer to a dealer where the term of the 
installment obligation is based on the time that the property is 
resold by the dealer. 

The denial of use of the installment method for sales pursuant to 
revolving credit plans and for sales of certain publicly traded prop- 
erty is effective for sales after December 31, 1986. Taxpayers sell- 
ing property on revolving credit plans are permitted to spread any 
adjustment arising from the change in accounting method over a 
period not exceeding four years. The limitation on the use of the 
installment method based on the ratio of the t£ixpayer's debt to 
assets is effective as of January 1, 1987, for sales on or after March 
1, 1986. 

D. Capitalization of Inventory, Construction, and Development Costs 

The conference agreement provides that, in general, uniform 
rules for determining costs that must be capitalized apply to all 
persons who produce property or acquire property for resale. Thus, 
the rules apply to inventory, noninventory property produced or 
held for sale to customers, and assets constructed for self-use. The 
rules are based on present law capitalization rules applicable to ex- 
tended period long-term contracts. Interest is subject to a special 
rule requiring capitalization only if the property is real property, 
long-lived property, or property requiring more than two years (one 
year in the case of items costing more than $1 million) to produce. 

An exception from the rules is provided for personal property 
held for resale by retailers and wholesalers whose average annual 
gross receipts do not exceed $10 million. Simplified methods of ab- 
sorbing costs will be provided under regulations for personal prop- 
erty held by resale by other retailers and wholesalers. 

The uniform capitalization rules generally apply to costs paid or 
incurred after December 31, 1986. In the case of inventories, the 
rules apply to the taxpayer's first taxable year beginning after De- 
cember 31, 1986. 

E. Long-Term Contracts 

The conference agreement requires certain changes to methods 
of accounting for long-term contracts. 

F. Reserves for Bad Debts 

The conference agreement generally repeals the reserve method 
of computing deductions for bad debts, other than for certain finan- 
cial institutions (see IX.A., below). The reserve method of comput- 
ing deductions for losses on debt obligations guaranteed by a dealer 
also is repealed. Taxpayers that are not allowed to continue to use 
the reserve method are allowed a deduction for bad debts when the 
debt becomes wholly or partially worthless. The balance of any re- 



29 

serve for bad debts or guarantees is taken into income ratably over 

a period of four years. , • • «. r*^ 

The provision is effective for taxable years be^ning after De- 
cember 31, 1986. A partner in a partnership or a shareholder m an 
S corporation, that would otherwise be required by this provision to 
include more than 12 months of income in a single taxable year, 
may include such excess in income rotably over a period ot tour 
taxable years. 

G. Taxable Year of Partnerships, S Corporations, and Personal 
Service Corporations 

The conference agreement requires that partnerships, S corpora- 
tions, and personal service corporations use a taxable year that 
generally conforms to the taxable year of their owners. 

A partnership must use (in order of priority) the taxable year ot 
the partners owning the majority of partnership profits and cap- 
ital, the taxable year of all of its principal partners, or the calen- 
dar year. An S corporation or a personal service corporation must 
use the calendar year. An exception is made for any partnership, b 
corporation, or personal service corporation that establishes to the 
satisfaction of the Secretary of the Treasury a business purpose for 
having a different taxable year. The deferral of income to partners 
or shareholders for any period is not to be treated as a business 
purpose. Personal service corporations may not deduct pa3niients to 
owner-employees prior to the year such payments are made. 

The provision is effective for taxable years beginning after De- 
cember 31, 1986. A partner in a partnership or a shareholder m an 
S corporation, that would otherwise be required by this provision to 
include more than 12 months of income in a single taxable year, 
may include such excess in income ratably over a period of four 
taxable years. 
H. Special Treatment of Certain Items 

1. Qualified discount coupons 

The conference agreement repeals the election to deduct the cost 
of redeeming qualified discount coupons that are received for re- 
demption after the close of the taxable year. A deduction will be 
allowed only for the cost of redeeming coupons that have been re- 
ceived by the close of the taxable year. The repeal of the election is 
effective for taxable years beginning after December 31, 1986. 

2. Utilities using accrual accounting 

The conference agreement provides that taxpayers using the ac- 
crual method of accounting must recognize income attributable to 
the sale or furnishing of utility services to customers not later than 
the year in which such services are provided to customers. The pro- 
vision is effective for taxable years beginning after December 61, 
1986. Any adjustment required by the provision is to be taken into 
income ratably over a period of four taxable years. 

3. Contributions in aid of construction 

The conference agreement provides that a utility must include iii 
gross income the value of any property, including money, that it 



30 

receives to encourage it to provide services to, or for the benefit of, 
the person transferring the property. The provision of present law 
that allows certain utilities to treat these amounts £is contributions 
to capital is repealed. The change is effective for contributions re- 
ceived after December 31, 1986. 

4- Discharge of indebtedness of solvent taxpayers 

The conference agreement repeals the provision of present law 
that allows income from the discharge of qualified business indebt- 
edness to be excluded from gross income. Income from the dis- 
charge of indebtedness must be recognized currently unless the dis- 
charge occurs in a title 11 (bankruptcy) case or when the debtor is 
considered to be insolvent. The provision is effective for discharges 
of indebtedness occurring after December 31, 1986. 



Title IX. Financial Institutions 

A. Reserve for Bad Debts 

1. Commercial banks 

Commercial banks may continue to compute their deductions for 
losses on bad debts under present law, except that "large banks" 
must use the specific charge-off method to compute the deduction 
for bad debts. A bank is considered to be a large bank if, for any 
taxable year beginning after 1986, the sum of the average adjusted 
bases of the assets of the bank (or of the assets of any controlled 
group to which the bank is a member) exceeds $500 million. 

Large banks required to change their method of accounting for 
bad debts must recapture the balance in reserve for bad debts over 
a period of four years (10 percent in the first year, 20 percent in 
the second, 30 percent in the third, and 40 percent in the fourth), 
or are required to account for bad debts on existing loans under a 
"cutoff method. A large bank is not required to recapture any of 
its existing reserves during any year in which the bank is "trou- 
bled," i.e., if the amount of its nonperforming loans exceeds 75 per- 
cent of its equity capital. 

These changes are effective for taxable years beginning after De- 
cember 31, 1986. 

2. Thrift institutions 

Thrift institutions that use the reserve method to compute their 
deductions for losses on bad debts may do so using either the expe- 
rience method allowed to small banks, or the percentage of taxable 
income method with the percentage reduced to eight percent from 
40 percent. In order to be eligible for the special treatment of bad 
debt reserves, at least 60 percent of the assets of the institution 
must be invested in qualif5dng assets. 

The excess of the bad debt deduction of thrift institutions com- 
puted under the percentage of taxable income method over the de- 
duction computed under the experience method is treated as a tax 
preference for alternative minimum tax purposes. The excess will 
not, however, constitute a preference item for purposes of the 20- 
percent reduction of present law for corporate tax preferences. 

These provisions apply to taxable years beginning after Decem- 
ber 31, 1986. 

B. Interest on Debt to Purchase or Carry Tax-Exempt Obligations 

The conference agreement disallows 100 percent (as opposed to 
20 percent under present law) of deductions of all financial institu- 
tions for interest expense allocable to tax-exempt obligations ac- 
quired after August 7, 1986. A 20-percent disallowance continues to 
apply with respect to tax-exempt obligations acquired after Decem- 
ber 31, 1982, and before August 8, 1986. Certain governmental and 

(31) 



32 

section 501(c)(3) organization bonds issued by small governmental 
units, in aggregate amounts not exceeding $10 million per year, 
will remain subject to a 20-percent disallowance. 

This provision is effective for taxable years ending after Decem- 
ber 31, 1986, with respect to tax-exempt obligations acquired after 
August 7, 1986. A transitional rule is provided for obligations ac- 
quired pursuant to a written commitment to purchase entered into 
before September 25, 1985. 

C. Net Operating Loss Carryovers of Financial Institutions 

The provision of present law allowing a carryback period of 10 
years and a carryforward period of five years for the net operating 
losses of depository institutions is repealed, effective for losses in- 
curred in taxable years beginning after December 31, 1986, except 
for the portion of the losses of commercial banks (not including 
thrift institutions) that are attributable to bad debts in t£«able 
years before 1994. Other losses incurred in taxable years beginning 
after 1986 are required to be carried back three years and carried 
forward 15 years in accordance with the general rules for net oper- 
ating losses. Losses incurred by thrift institutions in years after 
1981 and before 1986 may be carried back 10 years and carried for- 
ward eight years. 

D. Reorganizations of Financially Troubled Thrift Institutions 

The conference agreement repeals the special rules of present 
law that provide special relief to reorganizations of financially 
troubled thrift institutions. In general, these rules provide that the 
continuity of interest requirement is satisfied, and net operating 
losses may be carried over, if the depositors of a financially trou- 
bled thrift become depositors of the surviving corporation. In addi- 
tion, these rules provide that certain payments from the Federal 
Savings and Loan Insurance Corporation to financially troubled 
thrifts are exempt from the thrift's income and do not reduce its 
basis in assets. 

The repeal is effective for reorganizations occurring on or after 
January 1, 1989. 

E. Losses on Deposits in Insolvent Financial Institutions 

Under the conference agreement, individuals with deposits in 
certain insolvent financial institutions may elect to deduct as a cas- 
ualty loss any loss with respect to their deposits at the time it can 
be reasonably estimated, effective for losses incurred in taxable 
years beginning after December 31, 1982. 



Title X. Insurance Products and Companies 
A. Insurance Policyholders 

1. Exclusion for interest on installment payments of life in- 

surance proceeds 

The conference agreement repeals the provision of present law 
under which the income on the proceeds of life insurance that are 
paid to a surviving spouse as periodic payments is includible in 
gross income only to the extent that the amount of income paid 
during any taxable year exceeds $1,000. The provision is effective 
for amounts received by a beneficiary with respect to deaths occur- 
ring after the date of enactment. 

2. Treatment of structured settlement agreements 

The agreement limits the exclusion from income for qualified as- 
signments under structured settlement agreements to those assign- 
ments requiring the payment of damages on account of a claim for 
personal injury or sickness involving physical injury or sickness 
(including death), effective for assignments entered into after De- 
cember 31, 1986. 

3. Treatment of interest on loans from life insurance policies 

A deduction for interest on policyholder loans is not allowed in 
the case of loans aggregating more than $50,000 per officer, em- 
ployee, or owner of an interest in any trade or business carried on 
by the taxpayer. The legislative history restates the present-law 
rules relating to the deduction for interest on loans incurred to 
carry or purchase single premium life insurance contracts, includ- 
ing a Senate floor colloquy relating to universal life insurance. 

4. Treatment of policies to cover prearranged funeral expenses 

Life insurance policies purchased to cover payment of burial ex- 
penses or prearranged funeral expenses may be treated as life in- 
surance contracts if (1) the initial death benefit is $5,000 or less in 
the aggregate per policyholder, (2) the policies provide for fixed 
annual death benefit increases not exceeding certain amounts, and 
(3) the death benefit under the contract never exceeds $25,000. 

5. Deduction for nonbusiness casualty losses 

Under the agreement, in the case of a loss covered (wholly or 
partially) by insurance, a taxpayer is permitted to deduct a casual- 
ty loss for damages to property not used in a trade or business or 
in a transaction entered into for profit only to the extent of losses 
not covered by insurance and only if the taxpayer files a timely in- 
surance claim with respect to damage to that property. The provi- 
sion applies to losses sustained in taxable years beginning after De- 
cember 31, 1986. 

(33) 



34 

B. Life Insurance Companies 

1. Special life insurance company deduction 

Under the conference agreement, the special life insurance com- 
pany deduction equal to 20 percent of tentative life insurance com- 
pany taxable income (LICTI) is repealed, generally effective for tax- 
able years beginning after December 31, 1986. A special rule is pro- 
vided for a certain life insurance company. 

2. Tax-exempt organizations engaged in insurance activities 

The agreement provides, for taxable years beginning after De- 
cember 31, 1986, that certain organizations (described in sees. 
501(c)(3) or (4)) are entitled to tax exemption only if no substantial 
part of their activities is providing commercial-type insurance, in- 
cluding the issuance of annuity contracts. In addition, the commer- 
cial-type insurance activities of an otherwise tax-exempt organiza- 
tion are treated as an unrelated trade or business that is subject to 
tax under subchapter L. 

Commercial-type insurance does not include insurance provided 
at substantially below cost to a class of charitable recipients, inci- 
dental health insurance provided by a health maintenance organi- 
zation of a kind customarily provided by such organizations, or 
property and casualty insurance (such as fire insurance) provided 
directly or through a wholly owned corporation by a church or con- 
vention or association or churches. 

In the case of certain existing tax-exempt organizations provid- 
ing health insurance, the agreement provides that these organiza- 
tions are (1) taxable as stock property and casualty insurance com- 
panies, (2) allowed a deduction for regular tax purposes (not to 
exceed taxable income) equal to one quarter of the year's annual 
claims and administrative expenses less prior year's surplus, (3) 
given a fresh start with respect to accounting methods, including 
loss reserves, and (4) exempt from the provision of the conference 
agreement regarding unearned premiums of property and casualty 
insurance companies. The basis of assets of existing organizations 
is stepped up to fair market value immediately prior to the effec- 
tive date for purposes of determining gain. 

To be eligible for this special treatment, other organizations are 
required to satisfy certain conditions: (1) at least 10 percent of acci- 
dent and health insurance is provided to individuals and small 
groups (disregarding Medicare supplemental coverage), defining a 
small group as the lesser of 15 individuals or the number of indi- 
viduals required for a small group under State law, (2) full-year 
open enrollment (including conversions) is provided for individuals 
and small groups, (3) policies covering individuals provide full cov- 
erage of pre-existing conditions of high-risk individuals without a 
price differential (with a reasonable waiting period), and coverage 
is provided without regard to age, income, or employment status of 
persons under age 65, and (4) at least 35 percent of enrollment is 
community rated. 

Further, the conference agreement requires the Department of 
the Treasury to conduct a study of fraternal beneficiary associa- 
tions (sec. 501(c)(8)) that received gross annual insurance premiums 
in excess of $25 million in 1984. 



35 

Exemptions from the provision are provided for TIAA/CREF 
(pension business only), for certain church-sponsored insurance, for 
YMCA (retirement fund), for administrative services performed by 
municipal leagues, and for the Missouri Hospital Association. 

3. Physicians' and surgeons' mutual protection associations 

The conference agreement provides that contributions to a 
pooled malpractice insurance association are currently deductible 
to the extent they do not exceed the cost of a commercial insurance 
premium and are included in the association's income, and that re- 
funds of such contributions are deductible to the fund only to the 
extent included in income of the recipient. The provision applies to 
associations operating under State law prior to January 1, 1984, 
and is effective for contributions and refunds after the date of en- 
actment of the bill. 

4- Operations loss deduction of insolvent companies 

Under the conference agreement, a life insurance company may 
apply current losses from operations and loss carryovers against 
the increase in its taxable income attributable to amounts deemed 
distributed from the policyholder surplus account, if the company 
is required to be liquidated pursuant to a court order and certain 
other criteria are met. 

C. Property and Casualty Insurance Companies 

1. Inclusion in income of 20 percent of unearned premium re- 

serves 

Under the conference agreement, 20 percent of the annual in- 
crease in unearned premiums is included in property and casualty 
insurance company income. Also, 20 percent of the unearned pre- 
mium reserve outstanding at the end of the most recent taxable 
year beginning before January 1, 1987, is included ratably over a 
six year period commencing with the first taxable year beginning 
after December 31, 1986. 

In the case of insurance against default in the payment of princi- 
pal or interest on securities with a maturity of five years or more 
(i.e., bond insurance), the percentage of unearned premiums includ- 
ed in income is 10 percent, rather than 20 percent. 

If a property and casualty insurance company ceases to be sub- 
ject to tax as a property and casualty insurance company, the re- 
maining portion (if any) of the amount to be ratably included over 
six years is includible for the taxable year preceding the taxable 
year in which the company ceases to be taxed as a property and 
casualty insurance company. 

2. Treatment of certain dividends and tax-exempt income 

For taxable years beginning after December 31, 1986, a property 
and casualty insurance company's deduction for losses incurred is 
reduced by a portion of the company's tax-exempt income and the 
deductible portion of dividends received (with special rules for divi- 
dends from affiliates). The portion taken into account is 15 percent 
of tax-exempt income and the deductible portion of dividends re- 
ceived from investments made after August 7, 1986. 



36 

3. Treatment of loss reserves 

The deduction for unpaid losses (i.e., reported losses that have 
not been paid, estimates of losses incurred but not reported, resist- 
ed claims, and unpaid loss adjustment expenses) is limited to the 
amount of discounted unpaid losses. This provision applies to prop- 
erty and casualty lines of business reported on Schedules O and P 
of the annual statement approved by the National Association of 
Insurance Commissioners, to accident and health reserves (other 
than life insurance reserves subject to discounting under life insur- 
ance company tax rules), and to international and reinsurance 
lines of business. This treatment applies to loss reserves of both 
property and casualty insurance companies and life insurance com- 
panies to the extent such loss reserves are not subject to life insur- 
ance company reserve rules. Loss adjustment expenses of life insur- 
ance companies are not subject to discounting because they are not 
deductible. 

In the case of title insurance companies, the agreement applies 
the discounting rules to the title insurance State law unearned pre- 
mium reserves. The discounting period is the period over which the 
unearned premium reserves are deferred under State law, and the 
discount rate is the rate generally applicable to property and casu- 
alty insurers. Title insurance case reserves are subject to discount- 
ing under the same method as property and casualty insurance loss 
reserves. 

The amount of the discounted unpaid losses as of the end of any 
taxable year attributable to any accident year is determined by 
using (1) the gross amount to be subjected to discounting (i.e., the 
undiscounted loss reserves), (2) the pattern of payment of claims, 
including the duration in years over which the claims will be paid, 
and (3) the rate of interest to be assumed in calculating the dis- 
counted reserve. 

The interest rate to be applied is 100 percent of the applicable 
Federal midterm rate applied on a five-year rolling average basis. 
The loss payment patterns are to be promulgated by the Secretary 
of the Treasury for 1987 and every fifth year thereafter, taking ac- 
count of aggregate industry experience for each line of busir> ss. 

A company may elect to use its own loss payment pattern experi- 
ence. Special rules are provided for long-tail lines and for interna- 
tional and reinsurance lines of business. The provision is effective 
for taxable years beginning after 1986, with a fresh start provision 
and special treatment for reserve strengthening in taxable years 
beginning after December 31, 1985. 

4- Repeal of protection against loss account 

Effective for taxable years beginning after December 31, 1986, 
the deduction for contributions to the protection against loss (PAL) 
account for mutual property and casualty companies is repealed. 
Balances in the account are includible in income as under present 
law. 

5. Revision of special treatment for small companies 

Under the bill, property and casualty companies (whether stock 
or mutual) with net written premiums or direct written premiums 



37 

(whichever is greater) that do not exceed $350,000 for the taxable 
year are exempt from tax. Property and casualty companies 
(whether stock or mutual) with net written premiums or direct 
written premiums (whichever is greater) that exceed $350,000, but 
do not exceed $1,200,000, may elect to be taxed only on taxable in- 
vestment income. In the case of a controlled group, these amounts 
are determined on a group basis, applying 50-percent control test. 
The provisions are effective for taxable years beginning after De- 
cember 31, 1986. 

6. Study of property and casualty insurance companies 

Under the agreement, the Treasury Department is required to 
conduct a study of the tax treatment of policyholder dividends of 
mutual property and casualty insurance companies for regular as 
well as minimum tax purposes and an examination of whether the 
property and casualty insurance industry meets revenue targets 
projected by the agreement. 



Title XI. Pensions and Deferred Compensation; Employee 
Benefits; ESOPs 

A. Treatment of Tax-Favored Savings 

1. Individual retirement arrangements (IRAs) 

Under the conference agreement, deductible IRA contributions 
are permitted as under present law (1) if an individual (or a mar- 
ried couple) has adjusted gross income (AGI) under a phase out 
level, or (2) if the individual is not an active participant (or, in the 
case of a married individual, neither the individual nor his or her 
spouse is an active participant) in an employer-maintained retire- 
ment plan for any part of the plan year ending with or within the 
individual's taxable year. The phase out begins at $25,000 for an 
individual and $40,000 for a married couple filing a joint return. 
For purposes of the phaseout, AGI is determined without regard to 
any IRA contributions. 

For an individual who is an active participant in an employer- 
maintained retirement plan, the IRA deduction limit is reduced 
proportionately for AGI between $25,000 and $35,000. For married 
couples filing a joint return, the IRA deduction limit for each 
spouse is reduced proportionately for AGI between $40,000 and 
$50,000, if either spouse is an active participant in an employer- 
maintained retirement plan. 

For purposes of determining whether an individual is an active 
participant in an employer-maintained retirement plan, an employ- 
er-maintained retirement plan means (1) a qualified pension, profit- 
sharing, or stock bonus plan (sec. 401(a)), (2) a qualified annuity 
plan (sec. 403(a)), (3) a simplified employee pension (sec. 408(k)), (4) 
a plan established for its employees by the United States, by a 
State or political subdivision, or by any agency or instrumentality 
of the United States or a State or political subdivision, (5) a plan 
described in section 501(c)(18), or (6) a tax-sheltered annuity (sec. 
403(b)). 

The conference agreement provides that individuals may make 
nondeductible IRA contributions to the extent that they are not eli- 
gible to make deductible IRA contributions. Earnings on nonde- 
ductible IRA contributions are not subject to tax until they are 
withdrawn. 

Under the conference agreement, the rules relating to spousal 
IRA contributions are amended to eliminate the requirement that 
the spouse have no earned income for the year in order to be eligi- 
ble for the spousal IRA contribution. 

The conference agreement also amends present law to permit the 
acquisition by IRAs of certain gold and silver coins issued by the 
United States. 

The provisions are effective for taxable years beginning after De- 
cember 31, 1986, except that the provision eliminating the require- 

(38) 



39 

ment that the spouse have no earned income in order to be eligible 
for the spousal IRA contribution is effective for years beginning 
after December 31, 1985. 

2. Qualified cash or deferred arrangements (sec. 401(k) plans) 

Under the conference agreement, effective for taxable years be- 
ginning after December 31, 1986, the maximum amount that an 
employee can elect to defer for any taxable year under all cash or 
deferred arrangements in which the employee participates is limit- 
ed to $7,000. The $7,000 cap is adjusted for inflation by reference to 
percentage increases in the dollar limit under a defined benefit 
plan (sec. 415(d)). 

Effective generally for taxable years beginning after December 
31, 1986, and, in the case of plans maintained by State or local gov- 
ernment employers, for years beginning after December 31, 1988, 
the conference agreement modifies the special nondiscrimination 
test applicable to qualified cash or deferred arrangements by (1) 
modifying the percentage tests, (2) clarifjdng the rules for aggregat- 
ing elective contributions vsdth certain nonelective contributions for 
purposes of the special nondiscrimination test, (3) redefining the 
group of highly compensated employees and compensation to con- 
form to the new uniform definitions used generally for purposes of 
the nondiscrimination rules applicable to qualified plans and em- 
ployee benefit programs (described below), (4) establishing a mecha- 
nism for the return of contributions that violate the special nondis- 
crimination test, and (5) imposing an excise tax on contributions 
that are not returned (or forfeited) within a specified period of 
time. 

Under the conference agreement, the actual deferral percentage 
for an employer's highly compensated employees may not exceed 
125 percent of the actual deferral percentage of eligible nonhighly 
compensated employees. Alternatively, the actual deferral percent- 
age of an employer's highly compensated employees may not 
exceed the lesser of 200 percent of the actual deferral percentage of 
the nonhighly compensated employees, or the actual deferral per- 
centage of the nonhighly compensated employees plus two percent- 
age points. 

The conference agreement modifies certain present-law restric- 
tions and imposes several additional restrictions on qualified cash 
or deferred arrangements. First, qualifying total distributions may 
be made to a participant in a qualified cash or deferred arrange- 
ment on account of the sale of a subsidiary or of substantially all 
the assets used in a trade or business or the termination of the 
plan of which the arrangement is a part, effective for sales or ter- 
minations occurring after December 31, 1984. 

Second, the conference agreement limits hardship withdrawals 
under a qualified cash or deferred arrangement to the amount of 
an employee's elective deferrals. In addition, the conference agree- 
ment provides that a qualified cash or deferred arrangement 
cannot require, as a condition of participation in the arrangement, 
that an employee complete a period of service with the employer 
(or employers) maintaining the plan in excess of one year of serv- 
ice, effective for years beginning after December 31, 1988. 



40 

Under the conference agreement, effective for years beginning 
after December 31, 1988, an employer generally may not condition, 
either directly or indirectly, contributions and benefits (other than 
matching contributions) upon an employee's elective deferrals. An 
exception is provided for certain qualified offset arrangements. 

The conference agreement provides that qualified cash or de- 
ferred arrangements are not available to employees of State or 
local governments, unless the plan was adopted before May 6, 1986, 
or to employees of tax-exempt organizations, unless the plan was 
adopted before July 1, 1986. 

3. Employer matching contributions and employee contribu- 

tions 

Under the conference agreement, a special nondiscrimination 
test is applied to employer matching contributions and employee 
contributions under all qualified defined contribution plans and 
employee contributions under a defined benefit plan (to the extent 
allocated to a separate account on behalf of the employee). This 
nondiscrimination test applies in lieu of the usual nondiscrimina- 
tion rules applicable to the amount of contributions under qualified 
plans and is similar to the special nondiscrimination test applicable 
to qualified cash or deferred arrangements under the conference 
agreement. 

The provisions generally are effective for plan years beginning 
after December 31, 1986. 

4. Unfunded deferred compensation plans of State and local 

governments 

The conference agreement (1) applies the rules relating to un- 
funded deferred compensation plans to tax-exempt organizations; 
(2) requires that amounts deferred on a before-tax basis by an em- 
ployee under a simplified employee plan (SEP), a qualified cash or 
deferred arrangement (sec. 401(k)), or other elective contribution 
arrangement, be taken into account in determining whether the 
employee's deferrals under an eligible deferred compensation plan 
exceed the limits on deferrals under the eligible plan; (3) modifies 
the distribution requirements applicable to eligible deferred com- 
pensation plans; (4) permits certain rollovers between eligible de- 
ferred compensation plans; and (5) modifies the rule that deferrals 
under an eligible plan are includible in an employee's income when 
made available to the employee. An exception is provided for quali- 
fied State judicial plans. 

The provision relating to application of the unfunded deferred 
compensation plan rules to tax-exempt organizations is effective for 
years beginning after December 31, 1986. The distribution provi- 
sions are effective for taxable years beginning after December 31, 
1988. 

5. Deferred annuity contracts 

Under the conference agreement, if a deferred annuity contract 
is held by a person who is not a natural person (e.g., a corporation 
or a trust is not a natural person), then the contract is not treated 
as an annuity contract for Federal income tax purposes and the in- 
vestment income on the contract for any taxable year is treated as 



41 

ordinary income received or accrued by the owner of the contract 
during the taxable year. An exemption from the rule is provided 
for qualified funding assets purchased by structured settlement 
companies and annuities held by an employer with respect to a ter- 
minated pension plan. 

In addition, the conference agreement increases the early with- 
drawal tax to 10 percent and modifies the circumstances under 
which the additional income tax on early withdrawals from de- 
ferred annuity contracts will be imposed to conform generally to 
the circumstances under which the early withdrawal tax is im- 
posed under qualified plans pursuant to the conference agreement. 

The provisions are effective for years beginning after December 
31, 1986. 

6. Elective contributions to tax-sheltered annuities (sec. 403(b)) 

Under the conference agreement, effective for taxable years be- 
ginning after December 31, 1986, the maximum amount that an 
employee can elect to defer for any taxable year under all tax-shel- 
tered annuities in which the employee participates is limited to 
$9,500. The $9,500 cap will be adjusted for inflation when the 
$7,000 cap on elective deferrals under a qualified cash or deferred 
arrangement reaches $9,500. A special catch-up election is provid- 
ed. 

7. Simplified employee pensions (SEPs) 

The conference agreement revises the requirements relating to 
SEPs to permit an employee to elect to have SEP contributions 
made on the employee's behalf or to receive the contributions in 
cash without being treated as having constructively received the 
amounts contributed to the SEP pursuant to the employee's elec- 
tion. 

Elective deferrals under a SEP are to be treated like elective de- 
ferrals under a qualified cash or deferred arrangement and, thus, 
are subject to the $7,000 (indexed) cap on elective deferrals. Con- 
sistent with the rules applicable to elective deferrals under a quali- 
fied cash or deferred arrangement or t£ix-sheltered annuity under 
present law, elective deferrals under a SEP are treated as wages 
for employment tax purposes. 

The bill provides that the election to have amounts contributed 
to a SEP or received in cash is available only if all of the employ- 
ees of the employer are eligible to make such an election at least 
50 percent of the employees of the employer elect to have amounts 
contributed to the SEP and is available only in a taxable year in 
which the employer maintaining the SEP has 25 or fewer employ- 
ees as of the beginning of the year. 

In addition, elective deferrals under SEPs are subject to special 
nondiscrimination rules similar to the special nondiscrimination 
rules applicable to qualified cash or deferred arrangements. 

The conference agreement makes miscellaneous changes to the 
SEP requirements to decrease the administrative burden of main- 
taining a SEP. 

The provisions are effective for years beginning after December 
31, 1986. 



42 

8. Salary reduction permitted under section 501(c)(18) plans 

Under the conference agreement, employees who participate in a 
section 501(c)(18) pension plan are permitted to elect to make de- 
ductible contributions up to the lesser of $7,000 (coordinated with 
other elective deferrals) or 25 percent of the compensation of the 
employee includible in income for the taxable year subject to non- 
discrimination rules similar to the rules applicable to qualified 
cash or deferred arrangements. 

The provision is effective for years beginning after December 31, 
1986. 

B. Minimum Standards for Qualified Plans 

1. Coverage requirements for qualified plans 

Under present law, a qualified plan is required to cover employ- 
ees in general rather than merely the employees of an employer 
who are officers, shareholders, or highly compensated. A plan gen- 
erally satisfies the present-law coverage rule if (1) it benefits a cer- 
tain percentage of the employer's work force (percentage test), or 
(2) it benefits a classification of employees determined by the Secre- 
tary of the Treasury not to discriminate in favor of employees who 
are officers, shareholders, or highly compensated (classification 
test). 

The conference agreement modifies the present-law coverage 
rules to require that at least one of the following tests is satisfied: 

(a) at least 70 percent of all nonhighly compensated employees 
are covered by the plan; (b) the percentage of nonhighly compensat- 
ed employees covered by the plan is at least 70 percent of the per- 
centage of highly compensated employees covered by the plan; or 
(c) the group of employees covered by the plan satisfies the present- 
law classification, test and the average benefit provided to nonhigh- 
ly compensated employees (as a percentage of compensation) is at 
least 70 percent of the average benefit provided to highly compen- 
sated employees (as a percentage of compensation). For purposes of 
determining whether the average benefit provided to nonhighly 
compensated employees is at least 70 percent of the average benefit 
provided to highly compensated employees, all employer-provided 
benefits and employer contributions, including elective deferrals 
under a qualified cash or deferred arrangement, are taken into ac- 
count. 

In addition, the conference agreement (1) clarifies the circum- 
stances under which an employee will be treated as benefiting 
under a plan for purposes of the coverage rules; (2) modifies, for 
purposes of satisfying the new coverage requirements, the circum- 
stances under which certain categories of employees may be ex- 
cluded from consideration; (3) establishes a uniform objective defi- 
nition of those employees in whose favor discriminatory coverage is 
prohibited; (4) permits satisfaction of certain of the coverage rules 
on a controlled group or line of business basis; (5) establishes a defi- 
nition of a separate line of business or operating unit with a special 
safe-harbor rule; and (6) contains a special transition rule for cer- 
tain dispositions or acquisitions of a business. 



43 

The provisions are generally effective for plan years beginning 
after December 31, 1988. A special effective date applies to plans 
maintained pursuant to a collective bargaining agreement. 

2. Minimum, participation requirement 

Under the conference agreement, a plan is not a qualified plan 
unless it benefits at least (a) 50 employees or (b) 40 percent or more 
of all employees of the employer (if less). The requirement may not 
be satisfied by aggregating comparable plans. The requirement 
does not apply to multiemployer plans. The multiemployer plan ex- 
ception does not apply to plans maintained pursuant to collective 
bargaining agreements covering professionals (e.g., doctors or law- 
yers). 

The provisions are generally effective for plan years beginning 
after December 31, 1988. A special effective date applies to plans 
maintained pursuant to a collective bargaining agreement. In addi- 
tion, the conference agreement contains a special transition rule 
under which plans that do not comply with the minimum partici- 
pation rule must be merged or terminated by the end of the first 
plan year to which the rule applies. If a plan is terminated or 
merged under the special transition rule (1) the present value of ac- 
crued benefits must be calculated using an interest rate no lower 
than a specified rate, and (2) the excise tax on asset reversions does 
not apply to such a termination or merger. 

3. Nondiscrimination rules applicable to tax-sheltered annu- 

ities 

The conference agreement extends certain nondiscrimination 
rules to tax-sheltered annuity programs other than those main- 
tained by churches. With respect to employer (i.e., nonelective and 
matching) contributions to tax-sheltered annuity programs, the bill 
applies the general coverage and nondiscrimination requirements 
applicable to qualified pension plans. The conference agreement 
also directs the Secretary of the Treasury to develop simplified 
comparability rules for purposes of applying the coverage and non- 
discrimination requirements. 

With respect to elective contributions to tax-sheltered annuity 
programs (other than those maintained by churches), the confer- 
ence agreement provides that an employer that offers any employ- 
ee the opportunity to make elective deferrals is required to make 
the opportunity available to all employees, with no more than a de 
minimis contribution requirement. 

The conference agreement also clarifies the definition of an em- 
ployer for purposes of the nondiscrimination rules applicable to 
both employer contributions and elective deferrals under a tax- 
sheltered annuity program. In addition, the conference agreement 
provides that for purposes of applying the nondiscrimination rules, 
students who customarily work less than 20 hours per week may be 
disregarded. 

The provisions are generally effective for plan years beginning 
after December 31, 1988. 



44 

4- Integration with Social Security 

The conference agreement provides that a plan is not to be con- 
sidered discriminatory merely because the contributions and bene- 
fits under the plan favor highly compensated employees if the plan 
meets the new requirements (i.e., the disparity limits) of the confer- 
ence agreement relating to the integration of contributions or bene- 
fits under qualified plans. 

Under the conference agreement, a defined contribution plan 
meets the disparity limits for integrated plans only if the contribu- 
tion percentage under the plan for compensation over the integra- 
tion level does not exceed the lesser of (1) 200 percent of the contri- 
bution percentage for compensation up to the integration level or 
(2) the sum of the contribution percentage for compensation up to 
the integration level and a specified rate. 

In the case of an integrated excess defined benefit pension plan, 
the conference agreement limits the benefit percentage for compen- 
sation above the integration level to no more than 200 percent of 
the benefit percentage for compensation up to the integration level. 
In addition, the conference agreement further provides that the 
disparity between the benefit percentages for compensation above 
and below the integration level may not exceed an amount compa- 
rable to the disparity permitted under present lav/ and contains 
rules regarding the accrual of the disparity. The conference agree- 
ment also requires that any optional form of benefit, preretirement 
benefit, actuarial factor, or other benefit or feature provided by the 
plan with respect to remuneration in excess of the integration level 
specified by the plan for the year be provided with respect to remu- 
neration that is not in excess of that level. 

A defined benefit pension plan meets the requirements for inte- 
grated offset plans if it provides that a participant's accrued bene- 
fit derived from employer contributions (sec. 411(c)(1)) may not be 
reduced by reason of the offset by more than 50 percent of the ben- 
efit that would have accrued without regard to the reduction. The 
conference agreement further limits the size of the offset to an 
amount comparable to that permitted under present law and con- 
tains rules as to the rate at which the offset may accrue under a 
plan. 

The provisions are effective for plan years beginning after De- 
cember 31, 1988. A special effective date applies to plans main- 
tained pursuant to a collective bargaining agreement. 

5. Uniform definition of highly compensated employees 

The conference agreement provides a new uniform definition of 
the group of employees in whose favor discrimination is prohibited 
("highly compensated employees") that generally applies for pur- 
poses of the nondiscrimination rules for qualified plans and statu- 
tory employee benefit plans. 

An employee is treated as highly compensated with respect to a 
year if, at any time during the year or the preceding year, the em- 
ployee (1) was a five-percent ov/ner of the employer; (2) earned 
more than $75,000 in annual compensation from the employer; (3) 
earned more than $50,000 in annual compensation from the em- 
ployer and was a member of the top-paid group of employees, i.e.. 



45 

the top 20 percent of employees by pay during the same year; or (4) 
was an officer of the employer and received compensation greater 
than 150 percent of the dollar limit on annual additions to a de- 
fined contribution plan. Treatment of an employee as a highly com- 
pensated employee under the last three categories is subject to the 
top-lOO-employee rules, as in both bills. If for any year no officer of 
the employer received compensation in excess of this level, the 
highest paid officer of the employer is treated as a highly compen- 
sated employee. The $50,000 and $75,000 thresholds are indexed in 
the same manner as the indexation of the dollar limitation under 
section 415. 

6. Determining top-heavy status 

Under the conference agreement, a uniform accrual rule is used 
in testing whether a qualified plan is top-heavy (or super top- 
heavy), effective for plan years beginning after December 31, 1986. 
In determining whether a plan is top heavy, the fractional accrual 
rule is applied. However, at the employer's election, the top heavy 
determination may be based on any other accrual method if that 
method is used for benefit accrual purposes by all plans of the em- 
ployer. 

7. Includible compensation 

The conference agreement provides a limit of $200,000 on the 
amount of compensation that may be taken into account under any 
plan for purposes of both the nondiscrimination rules and the de- 
duction limits under section 404. The limit on includible compensa- 
tion is increased in the same manner as the dollar limit on annual 
additions under a defined benefit plan. The provision is effective 
for plan years beginning after December 31, 1986. 

8. Benefit forfeitures 

The conference agreement creates uniform rules for forfeitures 
under any defined contribution plan, effective for plan years begin- 
ning after December 31, 1985. 

9. Vesting standards 

The conference agreement provides (under the Code and ERISA) 
that a plan (other than a top-heavy plan subject to separate vesting 
requirements) is not a qualified plan of an employer unless a par- 
ticipant's employer-provided benefit vests at least as rapidly as 
under one of two alternative minimum vesting schedules. 

A plan satisfies the first schedule if a participant has a nonfor- 
feitable right to 100 percent of the participant's accrued benefit de- 
rived from employer contributions upon the participant's comple- 
tion of five years of service. A plan satisfies the second alternative 
schedule if a participant hsis a nonforfeitable right to at least 20 
percent of the participant's accrued benefit derived from employer 
contributions after three years of service, 40 percent at the end of 
four years of service, 60 percent at the end of five years of service, 
80 percent at the end of six years of service, and 100 percent at the 
end of seven years of service. 

A special rule is provided in the case of a multiemployer plan to 
require 100-percent vesting after 10 years of service. 



46 

The conference agreement also provides that a plan may not con- 
dition eligibility to participate in the plan on more than two years 
of service, and that a plan with a two-years-of-service eligibility re- 
quirement must provide for full and immediate vesting after two 
years of service. 

The provisions are generally applicable for plan years beginning 
after December 31, 1988, with respect to participants who perform 
at least one hour of service in a plan year to which the new provi- 
sions apply. A special effective date applies to plans maintained 
pursuant to a collective bargaining agreement. 

C Treatment of Distributions 

1. Uniform minimum distribution rules 

The conference agreement establishes a uniform commencement 
date for benefits under all qualified plans, IRAs, tax-sheltered an- 
nuities, custodial accounts, and unfunded deferred compensation 
plans of State and local government and tax-exempt employers. 
Under the agreement, distributions under a qualified retirement 
plan must commence no later than April 1 of the calendar year fol- 
lowing the calendar year in which the participant or owner attains 
age 70-1/2, without regard to the actual date of retirement. 

In addition, the agreement establishes a new sanction, in lieu of 
plan disqualification, in the form of an excise tax for failure to sat- 
isfy the minimum distribution rules. 

The provisions generally apply to distributions made after De- 
cember 31, 1988. 

2. Treatment of distributions 

The conference agreement (1) phases out capital gains treatment 
over six years beginning on January 1, 1987, and (2) eliminates 10- 
year forward averaging for taxable years beginning after December 
31, 1986, and, instead, permits a one-time election of five-year for- 
ward averaging for a lump-sum distribution received after attain- 
ment of age 59-1/2. Under a transition rule, a participant who at- 
tained age 50 by January 1, 1986, is permitted to make one election 
of five-year forward averaging or 10-year forward averaging (at 
present-law rates) with respect to a single lump sum distribution 
without regard to attainment of age 59-1/2, and to retain the cap- 
ital gain character of the pre-1974 portion of such a distribution. 
Under the transition rule, the capital gains portion would be taxed 
at a rate of 20 percent. 

The conference agreement also (1) modifies the present-law basis 
recovery rules for amounts distributed prior to a participant's an- 
nuity starting date to provide for pro-rata recovery of employee 
contributions, (2) eliminates the special three-year basis recovery 
rule of present law, (3) modifies the general basis recovery rules for 
amounts paid as an annuity to provide that each distribution is 
treated part as recovery of employee contributions and part as pay- 
ment of taxable employer contributions (until all employee contri- 
butions are recovered), and (4) restricts rollovers of partial distribu- 
tions to distributions due to separation from service. 

The new pre-annuity starting date basis recovery rules and the 
new restrictions on rollovers of partial distributions are generally 



47 

effective with respect to distributions made after December 31, 
1986, with a provision preventing avoidance of repeal of the three- 
year basis recovery rule. Under a transition rule, in the case of a 
plan that, on May 5, 1986, permitted the withdrawal of employee 
contributions before separation from service, distributions are 
treated as made first out of employee nontaxable contributions 
made before December 31, 1986. The post-annuity starting date 
basis recovery rules are generally effective with respect to individ- 
uals whose annuity starting date is after July 1, 1986. 

The conference aigreement also provides basis recovery rules (ef- 
fective January 1, 1987) for distributions from an IRA to which 
nondeductible contributions have been made, and permits rollovers 
from frozen deposits in bankrupt or insolvent savings and loan as- 
sociations after the 60-day rollover election period. 

S. Taxation of early distributions from qualified retirement 
plans 

The conference agreement applies a 10 percent additional income 
tax to withdrawals from a qualified plan, qualified annuity, tax- 
sheltered annuity, or IRA, made before death, disability, or attain- 
ment of age 59 1/2. The additional tax does not apply to certain 
distributions (1) in the form of an annuity payable over the life or 
life expectancy of the participant (or the lives or joint life and last 
survivor expectancy of the participant and the participant's benefi- 
ciary), (2) made after the participant has attained age 55, separated 
from service, and satisfied the conditions for early retirement 
under the plan, (3) used for payment of medical expenses to the 
extent deductible under sec. 213, (4) received from an employee 
stock ownership plan before January 1, 1990, (5) received prior to 
March 15, 1987, if made on account of separation from service in 
1986 if the recipient elects to be taxed on the distribution in 1986, 
or (6) to an alternate payee pursuant to a qualified domestic rela- 
tions order. 

The provisions generally are effective for distributions in taxable 
years beginning after December 31, 1986. 

4- Tax-sheltered annuities 

The conference agreement extends the withdrawal restrictions 
currently applicable to tax-sheltered custodial accounts to elective 
contributions made to a tax-sheltered annuity. Withdrawals on ac- 
count of hardship from a custodial account are permitted only to 
the extent of contributions made pursuant to a salary reduction 
agreement (but not earnings on those contributions). The provision 
is effective for years beginning after December 31, 1986. 

5. Loans under qualified plans 

The conference agreement modifies the rules relating to the tax 
treatment of loans under qualified plans by (1) limiting the ability 
of plan participants to maintain permanent loan balances, (2) limit- 
ing the availability of the extended repayment period for loans for 
principal residences to loans applied to the purchase of the partici- 
pant's principal residence, and (3) requiring level amortization of a 
loan over the permissible repayment period. 



48 

In addition, the agreement provides a deferral of the deduction 
(to the extent otherwise allowable under the provisions of the con- 
ference agreement) for interest paid by employees on loans secured 
by elective deferrals from a 401(k) plan or tax-sheltered annuity 
(sec. 403(b) plan), and also by key employees on loans from any 
qualified plan. The deferral would be accomplished by denying a 
deduction for interest, and increasing the participant's basis under 
the plan by the amount of nondeductible interest paid. 

The provisions are generally effective for amounts received as a 
loan after December 31, 1986. 

D. Tax Deferral Under Qualified Plans 

1. Overall limitations on contributions and benefits under 
qualified plans 

The conference agreement makes several changes to the overall 
limits on contributions and benefits under qualified plans, tax-shel- 
tered annuity programs, and SEPs of private and public employers. 

The normal retirement age, for purposes of the limit on benefits 
under a defined benefit pension plan, is conformed to the social se- 
curity retirement age. If the retirement benefit under a defined 
benefit plan begins before the social security retirement age (pres- 
ently, age 65), then the $90,000 limitation on annual benefits gener- 
ally is reduced so that it is the actuarial equivalent of an annual 
benefit of $90,000 beginning at the social security retirement age. 
Under transition rules provided by the conference agreement, ben- 
efits already accrued by a plan participant under an existing plan 
are not affected by the reductions for actuarial equivalence. The 
changes do not affect plans maintained by tax-exempt employers. 

Under the conference agreement, the dollar limit on annual ben- 
efits under a qualified defined benefit pension plan is phased-in 
over 10 years of participation. The agreement provides for rules 
under which nonabusive benefit increases are not limited by the 
phase-in. 

The conference agreement provides for qualified cost-of-living ar- 
rangements. The agreement clarifies the terms under which an em- 
ployee may obtain an employer-provided cost-of-living subsidy. 

The conference agreement provides special rules for commercial 
airline pilots, and participants in a qualified police or firefighters' 
defined benefit pension plan. The agreement clarifies the definition 
of a qualified police or firefighters' plan and provides for indexing 
of the limit applicable under the special rules for those plans. In 
addition, the agreement clarifies the application of the special rules 
for pilots who retire before age 60. 

With respect to defined contribution plans, the conference agree- 
ment adopts the rules of the House bill with respect to cost-of- 
living adjustments and clarifies the application of the limits for de- 
fined contribution plans. Although cost-of-living adjustments will 
be made to the defined benefit pension plan limit beginning in 
1988, no cost-of-living adjustments to the defined contribution plan 
limit will be made until the $30,000 defined contribution plan limit 
is equal to 25 percent of the defined benefit dollar limit. The cost- 
of-living adjustment will be determined by reference to the con- 
sumer price index. 



49 

Under the agreement, contributions made by retired non-key em- 
ployees for retiree medical coverage are not subject to the percent- 
age-of-compensation limit on annual additions. 

Under the conference agreement, the class of employers whose 
employees are entitled to the special catch-up elections for tax-shel- 
tered annuities is expanded to include employers that are health 
and welfare service agencies. The agreement also provides a techni- 
cal modification clarifying that the catch-up rules apply before sep- 
aration from service. 

The conference agreement provides for a 15-percent excise t£ix on 
benefit payments in excess of $112,500. Under the agreement, the 
tax does not apply to excess benefits accrued before August 1, 1986. 

The provisions generally are effective for years beginning after 
December 31, 1986. Special rules are provided in the case of plans 
maintained pursuant to collective bargaining agreements. 

2. Deductions for contributions to qualified plans 

The conference agreement makes several changes to the limits 
on employer deductions for contributions to qualified plans. The 
agreement (1) repeals the limit carryforward applicable to profit- 
sharing and stock bonus plans, (2) extends the 25-percent of com- 
pensation combined plan deduction limit to any combination of a 
defined benefit pension plan and a money purchase pension plan, 
profit-sharing, or stock bonus plan, and (3) applies a 10-percent 
excise tax to nondeductible employer contributions. The agreement 
includes a technical modification relating to fully insured plans. 

The provisions are effective for taxable years beginning after De- 
cember 31, 1986. 

3. Excise tax on reversion of qualified plan assets to employer 

The conference agreement imposes a 10-percent nondeductible 
excise tax on a reversion from a qualified plan. The tax is imposed 
on the person who received the reversion. The agreement provides 
that the tax does not apply to the portion of a reversion that is 
transferred to an ESOP under certain circumstances. 

The provision applies to reversions received after December 31, 
1985, with an exception for a certain employer. The special provi- 
sion for transfers to an ESOP expires for reversions received after 
December 31, 1988. 

E. Miscellaneous Pension and Deferred Compensation Provisions 

1. Discretionary contribution plans 

Under the conference agreement, an employer's contribution to a 
profit-sharing plan is not limited to the employer's current or accu- 
mulated profits. This provision applies without regard to whether 
the employer is tax-exempt. The provision applies for plan years 
beginning after December 31, 1985. 

2. Requirement that collective bargaining agreements be bona 

fide 

The conference agreement clarifies that no agreement will be 
treated as a collective bargaining agreement unless it is a bona fide 



50 

agreement between bona fide employee representatives and one or 
more employers. The provision is effective upon enactment. 

3. Penalty for overstatement of pension liabilities 

The conference agreement provides a new penalty in the form of 
a graduated addition to tax applicable to certain income tax over- 
statements of deductions for pension liabilities. As an addition to 
tax, this penalty will be assessed, collected, and paid in the same 
manner as a tax. This addition to tax applies only to the extent of 
any income tax underpayment that is attributable to such an over- 
statement. The penalty is similar to the present-law penalty for 
overvaluations of liabilities. 

The provision is generally effective after December 31, 1986. 

4- Treatment of certain fishing boat crews as self-employed in- 
dividuals 

Under the conference agreement, members of fishing boat crews 
(described in sec. 3121(b)(20) are treated as self-employed individ- 
uals for purposes of the rules relating to qualified pension, profit- 
sharing, or stock bonus plans. 

The provision is effective for taxable years beginning after De- 
cember 31, 1986. 

5. Cash out of certain accrued benefits 

The conference agreement amends the rules of the Code and 
ERISA relating to cash outs of accrued benefits to require that, for 
purposes of determining the present value of a participant's ac- 
crued benefit, a plan is to compute the first $25,000 of the present 
value of a benefit by using an interest rate no greater than the in- 
terest rate (deferred or immediate, whichever is appropriate) that 
would be used by the PBGC (as of the date of distribution) upon the 
plan's termination. The remaining portion of the present value of 
the benefit is to be determined by using an interest rate no greater 
than 120 percent of the PBGC interest rate. In addition, the confer- 
ence agreement clarifies that certain plan amendments adopting 
the provision will not constitute a cutback of a participant s ac- 
crued benefit. 

The provision is applicable for distributions after December 31, 
1984. However, it does not apply to distributions that were made 
after December 31, 1984, and before the date of enactment, if such 
distributions were made in accordance with the requirements of 
regulations issued under the Retirement Equity Act of 1984. 

6. Time required for plan amendments, issuance of regula- 

tions, and development of section 401(k) master and pro- 
totype plans 

Under the conference agreement a delayed effective date is pro- 
vided for plan amendments to comply with the provisions of the 
conference agreement relating to qualified plans. 

Further, the conference agreement provides that the Treasury 
Department is to issue final regulations by February 1, 1988, for (1) 
the rules relating to the integration of benefits under qualified 
plans, (2) the coverage requirements applicable to qualified plans, 
(3) the amendments applicable to qualified cash or deferred ar- 



51 

rangements (sec. 401(k) plans), and (4) the new nondiscrimination 
rules for employer matching and employee contributions (sec. 
401(m)). 

The conference agreement provides that the Treasury Depart- 
ment is to begin issuing determination letters with respect to 
master and prototype plans that include qualified cash or deferred 
arrangements by May 1, 1987. 

7. Exemption from the survivor benefit requirements of the 

Retirement Equity Act of 1984 

The conference agreement exempts a plan from the survivor ben- 
efits requirements of the Retirement Equity Act of 1984, if (1) the 
plan was established prior to January 1, 1954, as a result of an 
agreement between employee representatives and the Federal Gov- 
ernment during a period of Government operation, under seizure 
powers, of a major part of the productive facilities of the industry, 
and (2) under the plan, participation is substantially limited to par- 
ticipants who, before January 1, 1976, ceased employment covered 
by the plan. 

8. Employee leasing 

The conference agreement modifies the safe harbor under which 
an individual (a leased employee) who performs certain services for 
another person (the recipient) on a substantially full time basis will 
not be treated as an employee of the recipient for purposes of the 
nondiscrimination rules. The conference agreement (1) raises the 
safe harbor contribution rate under section 414(n)(5) for a plan 
maintained by a leasing organization from 7-1/2 percent to 10 per- 
cent; (2) requires as a condition of the safe harbor that the leasing 
organization cover 100 percent of its employees (excluding employ- 
ees who have compensation of less than $1000 for the year); and (3) 
provides that the safe harbor may not be used if more than 20 per- 
cent of the individuals performing substantial services for the re- 
cipient organization are leased employees. The conference agree- 
ment also provides an exemption from the employee leasing record- 
keeping requirements for recipient organizations that have no top- 
heavy plans and with respect to which only a de minimis percent- 
age of individuals performing substantial services are not employ- 
ees. 

F. Employee Benefit Provisions 

1. Nondiscrimination rules for certain statutory employee ben- 
efit plans and cafeteria plans 

The conference agreement establishes comprehensive nondis- 
crimination rules for certain statutory employee benefit plans. 
Under the agreement, a highly compensated employee who is a 
participant in any discriminatory statutory employee benefit plan 
is taxed generally only on the value of the discriminatory portion 
of the employer-provided benefit under the plan if such portion is 
timely reported. 

The agreement (1) revises the nondiscrimination rules applicable 
to group-life term insurance plans and self-insured accident or 
health plans; (2) extends those rules to insured accident or health 



52 

plans; (3) establishes a new nondiscrimination test applicable to de- 
pendent care assistance plans; (4) applies the uniform definition of 
highly compensated employee, employer, and compensation gener- 
ally applicable under the nondiscrimination rules for qualified 
plans; (5) permits satisfaction of the nondiscrimination tests on a 
controlled group, line of business, or operating unit basis; and (6) 
contains a special transition rule for certain dispositions or acquisi- 
tions of a business. Present-law concentration tests would continue 
to apply. Educational assistance and group legal services are not 
subject to the new nondiscrimination rules because the exclusions 
for those benefits are scheduled to expire, under the agreement, 
before the effective date of the new nondiscrimination rules. 

Under the new nondiscrimination tests, employee benefit plans 
are subject to eligibility tests and a benefits test, applicable to each 
t)T)e of benefit. In applying the tests to health plans, employees 
with other health coverage can be disregarded, and family health 
coverage can be tested separately. In the case of group-life term in- 
surance, the nondiscrimination rules can be applied to the value of 
coverage provided, expressed as a percentage of compensation (with 
the same cap on includible compensation applicable to qualified 
plans). Generally, different types of benefits can be aggregated for 
purposes of satisfying the benefits test, except that health plans 
must satisfy the benefits test without aggregation with other types 
of plans. 

Under the conference agreement, benefits provided under a cafe- 
teria plan are generally subject to the new nondiscrimination rules. 
In addition, the present-law cafeteria plan availability test contin- 
ues to apply. 

Under the conference agreement, full-time life insurance sales- 
men can participate in cafeteria plans, and employees of education- 
al organizations may elect post-retirement life insurance coverage 
under a cafeteria plan. The agreement also provides that salary re- 
duction under cafeteria plans is excluded from the FICA and 
FUTA wage bases. 

The nondiscrimination rules are generally effective for the later 
of: (1) plan years beginning after December 31, 1987, or (2) (he ear- 
lier of plan years beginning at least three months following the is- 
suance of Treasury regulations or after December 31, 1988. 

2. Deductibility of health insurance costs of self-employed in- 
dividuals 

The conference agreement provides a deduction for 25 percent of 
the amounts paid for health insurance for a taxable year on behalf 
of a self-employed individual and the individual's spouse and de- 
pendents. No deduction is allowable to the extent the deduction ex- 
ceeds the self-employed individual's net earnings from self employ- 
ment (sec. 1402(a)) for the taxable year. In addition, no deduction is 
allowable for any taxable year for which the self-employed individ- 
ual is eligible to participate (on a subsidized basis) in a health plan 
of an employer of the self-employed individual or such individual's 
spouse. 

The provision is effective for taxable years beginning after De- 
cember 31, 1986, and before Januray 1, 1990. 



53 

3. Exclusions for educational assistance programs, qualified 

group legal services, and dependent care assistance pro- 
grams 

The conference agreement retroactively extends the exclusions 
from gross income for educational assistance and group legal serv- 
ices and the tax exemption for qualified group legal services orga- 
nizations for two years through 1987. 

In addition, the agreement increases the cap on annual excluda- 
ble educational assistance benefits to $5,250 from $5,000. 

The provisions generally are effective (1) in the case of education- 
al assistance benefits, for taxable years beginning after December 
31, 1985, and (2) in the case of group legal services benefits and the 
tax exemption for qualified group legal services organizations, for 
taxable years ending after December 31, 1985. A special rule is pro- 
vided for group legal services benefits provided under a cafeteria 
plan. 

The conference agreement imposes a $5,000 cap ($2,500 for a 
married individual filing separately) on the exclusion for depend- 
ent care assistance. The provision is effective for taxable years be- 
ginning after December 31, 1985. 

4. Faculty housing 

The conference agreement provides generally that, for Federal 
tax purposes, the fair market value of the use (on an annualized 
basis) of qualified campus lodging furnished by, or on behalf of, a 
school, college, or university is to be treated as not greater than 
five percent of the appraised value for the lodging, but only if, 
under Treasury regulations, an independent appraisal of the fair 
market value is obtained by a qualified appraiser. 

The provision is effective for taxable years or periods beginning 
after December 31, 1985. 

5. Health benefits for retirees 

The Senate provision is not included in the conference agree- 
ment. 

6. Accrued vacation pay 

Under the conference agreement, the special rule allowing a de- 
duction for additions to a reserve account for vacation pay (sec. 
463) is limited to the vacation pay that is paid during the current 
taxable year or within 81/2 months after the close of the taxable 
year of the employer with respect to which the vacation pay was 
earned by the employees. 

The provision is effective for taxable years beginning after De- 
cember 31, 1986. 

G. Employee Stock Ownership Plans (ESOPs) 

1. Repeal of employee stock ownership tax credit 

The conference agreement repeals the special payroll-based 
ESOP tax credit for compensation paid or accrued after December 
31, 1986. A special transition rule is provided. 



54 

2. Certain additional tax benefits relating to ESOPs 

The conference agreement permits an exclusion from the gross 
estate of 50 percent of the qualified proceeds from a qualified sale 
of employer securities. Under the conference agreement, a quali- 
fied sale means any sale of employer securities (within the mean- 
ing of sec. 409(1)) by the executor of an estate to (1) an ESOP, or (2) 
an eligible worker-owned cooperative (as defined in sec. 1042(c)(2)). 
The provision is effective for sales after the date of enactment and 
before January 1, 1992. 

Under the conference agreement, the deduction for dividends 
paid on ESOP stock is expanded to apply to dividends that are used 
to repay ESOP loans used to acquire the stock on which the divi- 
dends are paid. The provision is effective for taxable years begin- 
ning after the date of enactment. 

The conference agreement extends the 50-percent exclusion for 
interest paid on securities acquisition loans (sec. 133) to refinancing 
of loans used to acquire employer securities after May 23, 1984. In 
addition, the conference agreement modifies the exclusion in two 
respects. First, the conference agreement provides that the exclu- 
sion is also available with respect to a loan to a corporation to the 
extent that, within 30 days, employer securities are transferred to 
the plan in an amount equal to the proceeds of the loan and such 
contributions are allocable to participants' accounts within one 
year after the date of the loan. Second, under the conference agree- 
ment, a lender eligible for the interest exclusion is amended to in- 
clude a regulated investment company (as defined in sec. 851). 
These modifications are effective for loans used to acquire employ- 
er securities after the date of enactment. 

S. Changes in qualification requirements relating to ESOPs 

Under the conference agreement, additional requirements are 
provided for any ESOP. These additional qualification require- 
ments (1) permit distributions upon termination of an ESOP, (2) 
modify the distribution and put option requirements, (3) modify the 
special limits on allocations of contributions to an ESOP to con- 
form the definition of highly compensated employee to the new def- 
inition provided for qualified plans generally, (4) require stock 
bonus plans to satisfy the put option requirements applicable to 
ESOPs, (5) permit an eligible plan participant to direct the ESOP 
trustee to diversify a portion of the participant's account balance, 
(6) require the value of employer securities to be determined by an 
independent appraiser, and (7) eliminate, with respect to ESOPs 
maintained by certain closely held newspaper publishers, the pass- 
through voting requirements. 

The provision permitting distributions upon plan termination 
generally is effective for termination distributions made after De- 
cember 31, 1984. The distribution requirements and the extension 
of the put option requirement to stock bonus plans are effective for 
distributions attributable to stock acquired after December 31, 
1986. The modifications of the put option requirement are effective 
with respect to stock acquired after the date of enactment. The 



55 



modified definition of highly compensated employees is effective for 
years beginning after December 31, 1988. The diversification re- 
quirements are effective with respect to ESOPs adopted after De- 
cember 31, 1986, and contributions made to an existing ESOP after 
December 31, 1986. 



Title XII. Foreign Tax Provisions 
A. Foreign Tax Credit 

1. Foreign tax credit limitation 

The overall foreign tax credit limitation of present law is re- 
tained. The separate limitation for interest income is replaced with 
separate limitations for passive income, shipping income, and bank- 
ing income. Passive income includes certain categories of income 
described under the anti-tax haven rules (subpart F). 

The conference agreement adopts a de minimis rule only for con- 
trolled foreign corporations. Coordination rules are provided for 
controlled foreign corporations that have no subpart F inclusions 
because they satisfy the subpart F de minimis rule. The subpart F 
de minimis rule is amended so that it applies if gross foreign base 
company income is less than the lesser of (1) five percent of gross 
income or (2) $1 million. 

The conference agreement contains a modified high tax kickout. 

Taxable interest payments from controlled foreign corporations 
to related persons consist of passive income to the extent of the 
payor's passive income (computed prior to the operation of subpart 
F). There is a separate foreign tax credit limitation for each non- 
controlled foreign corporation that pays dividends eligible for 
deemed paid foreign tax credit (with separate treatment for 
amounts attributable to high withholding tax interest). Interest re- 
ceived from noncontrolled foreign corporations is treated as passive 
income. Rents and royalties received from noncontrolled foreign 
corporations are treated as passive or active without reference to 
look-through rules. Interest earned in connection with export ac- 
tivities of the taxpayer or a related person is not subject to the 
banking limitation or the high withholding tax limitation described 
below. These provisions are effective for taxable years beginning 
after 1986, subject to certain transitional relief. 

2. Credit for high withholding taxes on interest 

Foreign gross withholding taxes on interest that are at least five 
percent of the gross amount are subject to a separate foreign tax 
credit limitation unless the loan is to finance exports of the taxpay- 
er or related person. This provision is generally effective for taxes 
paid in taxable years beginning after 1986, but transitional relief is 
provided. 

3. Deemed-paid credit 

The deemed paid credit for a U.S. corporation's share of foreign 
taxes paid by a foreign corporation is determined with respect to 
the foreign corporation's multi-year pool of accumulated earnings 
and profits. Earnings and profits generally are computed in the 
same manner for actual distributions as they are now for subpart F 

(56) 



57 

inclusions. These rules are generally effective for earnings and 
profits accumulated in taxable years beginning after 1986. 

4. Effect of foreign and U.S. losses on foreign tax credit 

Foreign source losses reduce all types of foreign source income 
before reducing U.S. source income. U.S. losses reduce categories of 
foreign income pro rata. This provision applies to losses incurred in 
taxable years beginning after 1986. 

5. Subsidies 

The conference agreement clarifies that foreign taxes that are re- 
bated directly or indirectly are not creditable. This provision ap- 
plies to taxable years beginning after 1986. 

6. Carrybacks 

Foreign tax credits that are currently unusable only because of 
the bill's rate reductions cannot be carried back for use in higher- 
rate taxable years. 

B. Source Rules 

1. Income from purchase and sale of inventory-type property 

Present law generally is retained for U.S. persons (i.e., the title 
passage rule), while income earned by a foreign person attributable 
to a fixed place of business within the United States is U.S. source. 
A Treasury study will evaluate the title passage rule. 

2. Income from intangible property 

With respect to royalty income, the conference agreement re- 
tains the place-of-use source rule of present law. With respect to 
sales income, unless the amount received is contingent on the use 
of the intangibles, the source is generally in the country of resi- 
dence of the seller. However, for U.S. persons, sales involving a for- 
eign office will yield foreign source income (if the income is subject 
to at least a 10-percent foreign tax). In addition, income earned by 
a foreign person attributable to a fixed place of business within the 
United States is U.S. source. 

3. Income from sale of other personal property 

Under the conference agreement, recapture income derived from 
sales of personal property used by the seller in a business is 
sourced where deductions with respect to such property previously 
offset income. Income in excess of those deductions is sourced ac- 
cording to present law. Income derived from sales of other personal 
property, including passive investment property, is generally 
sourced in the country of residence of the seller. However, for U.S. 
persons, sales involving a foreign office will yield foreign source 
income (if the income is subject to at least a 10-percent foreign tax). 
Certain sales of corporate stock are sourced in the country where 
the corporation whose stock is sold did most of its business. In addi- 
tion, income earned by a foreign person attributable to a fixed 
place of business within the United States is U.S. source. 



58 

^. Transportation income 

The conference agreement sources transportation income from 
United States-foreign routes as 50-percent U.S. source income and 
50-percent foreign source. (Present law generally treats most trans- 
portation income earned on such routes as foreign source income.) 
The special U.S. sourcing rule for income and expenses associated 
with vessels or aircraft constructed in the United States and leased 
to U.S. persons is repealed. The conference agreement also repeals 
a similar rule for transportation income earned in leasing certain 
aircraft used on United States-U.S. possessions routes. The repeal 
of both special rules is subject to a grandfather rule. 

The reciprocal tax exemption for foreign persons' shipping and 
aircraft income is available only if a foreign person's country of 
residence gives U.S. persons an equivalent foreign tax exemption. 
Eligibility for the reciprocal exemption is extended to bareboat 
charter income. In addition, a four-percent gross basis tax is gener- 
ally imposed on U.S. source transportation income of foreign per- 
sons not resident in countries that provide reciprocal tax exemp- 
tions to U.S. carriers. 

5. Other offshore income and income earned in space 

The conference agreement generally sources other offshore 
income and income earned in space in the recipient's country of 
residence. Certain communications income is sourced half in the 
place of transmission, half in the place of reception. 

6. Dividend and interest income 

In general, interest and dividend income paid by a U.S. corpora- 
tion that earns more than 80 percent of its income from an active 
foreign business (an "80/20" company) is foreign source to the 
extent that the company's income is derived from foreign sources. 
Dividends paid to U.S. persons are U.S. source, however. A similar 
rule applies to interest paid by "80/20 individuals". The conference 
agreement also restructures certain interest income exemptions. 

7. Allocation of interest and other expenses {other than re- 

search and development) 

The conference agreement generally requires corporate members 
of affiliated groups to allocate all expenses between U.S. and for- 
eign income on a consolidated group basis. Certain corporations 
that cannot join in filing consolidated returns can continue to allo- 
cate expenses on a separate company basis. Authority to require 
netting of interest expense and interest income is provided for in 
limited cases. The asset method of allocating interest expense is 
modified and the optional gross income method is eliminated. Tax- 
exempt income and assets are not taken into account for purposes 
of allocating expenses. The new interest allocation rules will be 
phased in over three to five years in certain cases. Other transi- 
tional relief is provided. 

8. Allocation of R&D expenses 

For one year, taxpayers are to allocate half the expenses for 
U.S.-performed R&D to U.S. source income, and the other half on 



59 

the basis of sales or gross income. (The Statement of Managers will 
indicate that legislative intervention is appropriate until the Treas- 
ury Department resolves the incompatibility between the suspend- 
ed Treasury regulations and foreign tax systems.) After one year, 
starting with taxable years beginning after August 1, 1987, a sus- 
pended Treasury Regulation generally requiring allocation on the 
basis of sales or gross income will take effect. 

9. Effective date 

The rules governing the source of income are generally effective 
for taxable years beginning after 1986, although the bill provides 
certain transitional relief. Certain rules applicable to foreign tax- 
payers apply to transactions occurring after March 18, 1986. 

C. Taxation of U.S. Shareholders of Foreign Corporations 

1. Tax haven income generally 

Interest, dividends, and gains received by banks and insurance 
companies (with an export finance exclusion), insurance income, 
amounts equivalent to interest, income earned in space or outside 
any country, and net gains from transactions in commodities, for- 
eign currency, and certain other property generally are taxed cur- 
rently if earned by controlled foreign corporations. Certain excep- 
tions to the Code's rules that currently tax certain "tax-haven" 
income of foreign subsidiaries of U.S. shareholders are repealed, in- 
cluding the exclusion for reinvested shipping income. The subjec- 
tive tax avoidance safe-harbor rule is replaced with an objective 
test. To coordinate the subpart F rules and the passive basket 
rules, prior year deficits in earnings and profits and other compa- 
nies' deficits in earnings and profits do not reduce subpart F 
income. Income that is recaptured under the foreign loss recharac- 
terization rule is subpart F income in accordance with the charac- 
ter of the original income requiring recapture. 

2. Determination of U.S. control of foreign corporations 

The U.S. ownership requirement for imposition of the subpart F 
rules is amended. For the subpart F rules to apply to a foreign cor- 
poration, more than 50 percent of the vote or value (not merely 
vote) of that corporation must belong to 10-percent U.S. sharehold- 
ers. Similarly, for the foreign personal holding company rules to 
apply, more than 50 percent of the vote or value of a foreign corpo- 
ration must be owned by five or fewer U.S. individuals. 

3. De minimis tax haven income rule 

Present law is amended to reduce the 10 percent of gross income 
threshold for foreign base company income to the lesser of $1 mil- 
lion or five percent of gross income. 

4- Possessions-chartered corporations 

The exception in the subpart F rules for possessions-chartered 
corporations is repealed subject to a transition rule. 



60 

5. Application of accumulated earnings tax (AET) and per- 

sonal holding company (PHC) tax to foreign corporations 

Present law is amended to allow foreign corporations a net cap- 
ital gain deduction for purposes of calculating the AET or PHC tax 
only if the gains are taxed by the United States at the corporate 
level. This provision applies to transactions occurring after March 
1, 1986. 

6. Deduction for dividends received from foreign corporations 

The deduction for dividends received from foreign corporations is 
modified to extend to dividends from corporations earning either 
any amount of U.S.-connected income or dividends from U.S. sub- 
sidiaries. The deduction is limited to 10-percent U.S. corporate 
shareholders, and is to be calculated on a net basis. Any amount 
eligible for the deduction is to be treated as U.S. source. Rules are 
provided to prevent double benefits. 

7. Delayed effective date for 1984 amendment to earnings and 

profits rules 

The conference agreement extends through 1987 the delay in the 
application to foreign corporations of the 1984 Act's amendments to 
the earnings and profits rules relating to installment sales. 

8. Effective date 

Except as indicated above, the conference agreement's rules ap- 
plicable to income earned through foreign corporations are general- 
ly effective for taxable years beginning after 1986. 

D. Special Tax Provisions for U.S. Persons 

1. Possession tax credit 

The conference agreement retains the existing possession tax 
credit with certain modifications. The optional cost sharing method 
of allocating intangible income is changed to require that the cost 
sharing payment be determined as the greater of (1) 110 percent of 
the payment determined under present law or (2) an arm's-length 
royalty. The conference agreement also requires an increase in the 
cost sharing payment (20 percent above the present law payment), 
and makes a technical correction thereto, for purposes of the 50/50 
profit split method. The active income test for possession corpora- 
tion status is increased from 65 to 75 percent. Income from loans 
for active business assets and development projects in qualified 
Caribbean Basin Initiative countries is eligible for U.S. tax exemp- 
tion. Compliance rules are provided, and a good faith effort to im- 
plement Puerto Rico's twin plan+ program is expected. In addi- 
tion, the requirement that funds be received in a possession to 
qualify for the section 936 credit does not apply to active business 
income from an unrelated party. Finally, section 936 treatment is 
extended to the U.S. Virgin Islands. These provisions are generally 
effective for taxable years after 1986. 

3. Taxation of certain employees in Panama 

The conference agreement clarifies that the Panama Canal 
Treaty and its implementing agreements do not exempt U.S. tax- 



61 

payers from U.S. tax. The conference agreement provides that 
Panama Canal Commission and Defense Department employees 
are entitled to certain tax-free allowances like those available for 
State Department employees. The agreement's clarification of the 
effect of the Panama Canal treaty is effective for all taxable years. 
The rule concerning taxation of employees' allowances applies for 
taxable years beginning after 1986. 

3. Exclusion for private sector earnings of Americans abroad 

The conference agreement reduces the maximum annual exclu- 
sion for foreign earned income of Americans working abroad, from 
the present $80,000 to $70,000. It denies this exclusion to Ameri- 
cans in foreign countries to which travel is prohibited by law. 
These provisions are effective for taxable years beginning after 
1986. 

4. Transfers of intangibles to related parties outside of the 

U.S 

The payment for intangibles received from foreign corporations 
by related U.S. persons shall be commensurate with the actual 
income attributable to the intangible. These rules generally apply 
to taxable years beginning after 1986, with respect to intangibles 
transferred after November 16, 1985. 

5. Compliance provisions applicable to U.S. persons resident 

abroad 

The conference agreement requires that passport and green card 
applicants complete an IRS information return. It also requires 
withholding on pension payments to persons with foreign address- 
es. These provisions apply to taxable years beginning after 1986. 

6. Foreign investment companies (FICs) 

Present law is amended to require either payment of an interest 
charge on eventual recognition of income earned by U.S. investors 
through passive FICs (subject to a gain limitation) or current recog- 
nition, and to apply these rules to U.S. investors irrespective of the 
degree of aggregate U.S. ownership. This provision is effective for 
taxable years beginning after 1986. 

E. Treatment of Foreign Taxpayers 

1. Branch profits tax 

The branch profits tax proposed by the President as a substitute 
for the present dividend withholding tax is generally adopted. The 
conference agreement generally retains present law (but with a re- 
duction of present law's 50 percent income threshold to 25 percent) 
when a treaty allows present law to apply but would not allow a 
branch profits tax to apply. The withholding tax on interest is 
based on the deduction taken by the branch, with amounts deduct- 
ed in excess of actual branch payments treated as interest paid to a 
home country parent. The conference agreement does not override 
treaties, including those regarding dividend and interest payments, 
except in treaty shopping cases. These rules are effective for tax- 
able years beginning after 1986. 



62 

2. Retain character of effectively connected income 

The conference agreement treats income or gain as effectively 
connected with a U.S. trade or business if it is attributable to a dif- 
ferent taxable year and would have been so treated if it had been 
taken into account in the other year. This rule applies to taxable 
years beginning after 1986. 

3. Tax-free exchanges by expatriates 

The tax-avoidance expatriate rules under present law are applied 
to gains on the sale of property the basis of which was determined 
by reference to U.S. property. This rule applies to sales or ex- 
changes of property received in exchanges after September 25, 
1985. 

4. Excise tax on insurance premiums paid to foreign insurers 

The conference agreement does not contain the excise tax provi- 
sion of the House bill. Instead, tlie conference agreement adopts a 
provision that imposes current tax on each U.S. person who owns 
stock in any 25-percent or more U.S.-owned foreign insurance com- 
pany with respect to income from insuring risks of U.S. stockhold- 
ers and related parties, whatever the degree of ownership of the 
U.S. stockholder. An exception applies to insurance companies 
whose stock is publicly and freely traded. Similar rules apply to 
mutual companies. This income is separately boxed. The provision 
is effective for years beginning after 1986. Treasury is to study the 
impact of treaty waivers of the excise tax on the domestic rein- 
suance industry. 

5. Reporting by foreign controlled corporations 

The conference agreement requires foreign-controlled foreign cor- 
porations doing business in the United States and foreign-con- 
trolled U.S. corporations to report transactions with all related per- 
sons, whether or not a corporation. This provision is effective for 
taxable years beginning after 1986. 

6. Foreign investors in U.S. partnerships 

The agreement requires that domestic and foreign partnerships 
engaged in a U.S. trade or business withhold on certain distribu- 
tions to foreign partners. The agreement clarifies that the with- 
holding requirement applies to all distributions to a foreign part- 
ner when 80 percent or more of a partnership's income is U.S. busi- 
ness income (with a rule that requires withholding only on the per- 
centage of U.S. business income in cases of less U.S. business 
income), and coordinates this withholding provision with existing 
withholding provisions so as to avoid duplicative withholding. This 
provision is effective for taxable years beginning after 1986. 

7. Income of foreign governments 

The agreement provides that the tax exemption for foreign gov- 
ernments applies only to investment income. It provides that pay- 
ments from a controlled entity that engages in U.S. trade or busi- 
ness are not investment income, so they are taxable. The agree- 



63 

ment does not change the rules that apply to international organi- 
zations. This provision is effective on July 1, 1986. 

8. Transfer prices for imports 

Importers cannot claim a transfer price for income tax purposes 
that is higher than is consistent with the value they claim for cus- 
toms purposes. This provision applies to transactions entered into 
after March 18, 1986. 

9. Dual resident companies 

Losses of a U.S. corporation that offset a foreign corporation's 
foreign tax cannot offset any income of any other corporation for 
U.S. tax purposes. This provision applies to taxable years beginning 
after 1986. 

10. Earnings stripping: interest paid to related tax-exempt 
parties 

The agreement does not contain the Senate provision limiting 
the deduction for net interest paid or accrued to related tax-exempt 
parties. 

11. Definition of resident alien 

In determining whether an alien individual is a U.S. resident for 
U.S. income tax purposes under the 1984 Act's substantial presence 
test, days in which a professional athlete is present in the United 
States competing in certain charitable sports events will not be 
counted. This provision applies to periods after the bill's date of en- 
actment. 

F. Foreign Currency Exchange Gain or Loss 

The tax treatment of exchange gain or loss, including character, 
source, and timing, is clarified. Generally, exchange gain or loss 
arises if the exchange rate fluctuates between the date an item is 
taken into account for tax purposes and the date it is paid. In gen- 
eral, the conference agreement provides that exchange gain or loss 
is ordinary in nature. To the extent provided by regulations, a spe- 
cial rule will require a taxpayer to recognize gain or loss currently 
with respect to an item that is "hedged" by an offsetting position 
(e.g., a foreign currency futures contract). All business entities that 
account for foreign operations in a foreign currency are generally 
required to use a profit and loss translation method. For purposes 
of the direct foreign tax credit and the indirect foreign tax credit, a 
foreign tax is generally calculated on the basis of the exchange 
rate in effect on the date paid (the Mauvais Ami rule). 

These rules are effective for taxable years beginning after 1986. 

G. Tax Treatment of Possessions 

1. U.S. Virgin Islands 

The Virgin Islands will continue to use the mirror code. The 
Virgin Islands inhabitant rule is repealed for all open years (except 
as to V.I. income) with a targeted exception. To be exempt from 
U.S. withholding tax, 65 percent of a Virgin Islands corporation's 



64 

income must be effectively connected with a trade or business in a 
possession or in the United States. Anti-abuse rules are provided. 

2. Guam, the Commonweath of the Northern Mariana Is- 
lands (CNMI), and American Samoa 

After 1986, full authority will be granted to Guam and the CNMI 
to determine their own income tax laws (as American Samoa cur- 
rently does). To avoid U.S. withholding tax, 65 percent of a posses- 
sion corporation's income must be effectively connected with a 
trade or business in a possession or in the United States. Anti- 
abuse rules are provided. 

S. Effective date 

The bill's rules coordinating United States and possessions tax- 
ation generally apply to taxable years beginning after 1986, or as 
soon as the applicable possession enters into an implementation 
agreement with the United States in tax matters. 



Title XIII. Tax-Exempt Bonds 
A. Tax-Exempt Bond Provisions 

1. Bonds to finance general governmental operations 

The conference agreement retains the tax-exemption for interest 
on State and local government bonds used to finance traditional 
governmental operations. These bonds may continue to be issued 
without regard to many of the limitations applicable to bonds for 
persons other than States and local governmental units. 

Interest on bonds to provide conduit financing for persons other 
States and local governmental units (collectively referred to as 
"private activity bonds") is taxable unless a specific exception is 
provided in the Code. A bond generally is viewed as a private activ- 
ity bond if — 

(l)(a) an amount equal to or exceeding 10 percent of the pro- 
ceeds is to be used in a trade or business of a person or persons 
other than a State or local governmental unit and (b) direct or 
indirect payments equaling or exceeding 10 percent of the debt 
service on the bonds are made with respect to such trade or 
business use, or 

(2) an amount equal to or exceeding the lesser of five percent 

or $5 million of bond proceeds is to be used to make or finance 

loans to persons other than State or local governments. 

(In the case of bonds to finance output facilities, private use and 

payments with respect to that use must total less than the lesser of 

10 percent or $15 million per facility.) 

In addition, the conference agreement provides that private use 
of governmental bond proceeds in excess of five percent must be re- 
lated to a governmental facility also being financed with the bonds. 
The private use is treated as related only if the financing provided 
for the private use is proportional to the total financing provided 
by the issue for the related governmental facility. 

2. Exceptions for certain private activity bonds 

Present law includes several exceptions permitting tax-exemp- 
tion for interest on bonds for private activities. These exceptions 
are for (a) bonds for section 501(c)(3) organizations; (b) industrial de- 
velopment bonds (IDBs); (c) student loan bonds issued in connection 
with certain Department of Education guarantees; (d) qualified 
mortgage bonds and qualified veterans' mortgage bonds; (e) certain 
bonds issued under non-Code statutes enacted before 1983; and (f) 
private loan bonds issued pursuant to certain specifically described 
State programs. 

The conference agreement continues many of the exceptions of 
present-law permitting tax-exempt financing for persons other than 

(65) 



66 

States and local governmental units. ^ First, interest on qualified 
501(c)(3) bonds remains tax-exempt. Second, interest on bonds to fi- 
nance certain exempt facilities is tax-exempt: airports, docks and 
wharves, mass commuting facilities, certain facilities for the fur- 
nishing of water, sewage and solid waste disposal facilities, quali- 
fied residential rental projects, ^ local district heating and cooling 
facilities, facilities for the local furnishing of electricity or gas, and 
certain hazardous waste disposal facilities. Third, interest on quali- 
fied redevelopment bonds, small-issue bonds, ^ and student loan 
bonds (including supplemental student loan bonds) is tax-exempt. 
Finally, interest on qualified mortgage bonds * and qualified veter- 
ans' mortgage bonds is tax-exempt. (The conference agreement also 
retains the option for States and local governments to elect to ex- 
change qualified mortgage bond authority and issue mortgage 
credit certificates, at an increased exchange rate of 25 percent.) 

3. State volume limitation 

Present law provides three separate State volume limitations for 
(a) IDBs and student loan bonds, (b) qualified mortgage bonds, and 
(c) qualified veterans' mortgage bonds. Certain types of IDBs and 
bonds for section 501(c) organizations are not subject to State 
volume limitations. 

The conference agreement provides a single State volume limita- 
tion for exempt-facility bonds, small-issue bonds, qualified redevel- 
opment bonds, student loan bonds, and qualified mortgage bonds. 
In addition, the private use portion (in excess of $15 million) of gov- 
ernmental bonds is subject to the new limitation unless specifically 
excluded from the cap. The new volume limitation for each State is 
equal to the greater of $75 per resident or $250 million per annum 
until December 31, 1987, after which date it is reduced to $50 per 
resident or $150 million per annum. There are no special set-asides 
under this volume limitation. In general, the new volume limita- 
tion is administered in a manner similar to the present-law volume 
limitations on IDBs and student loan bonds and on qualified mort- 
gage bonds. Thus, a Federal allocation formula is provided, subject 
to being overridden by gubernatorial proclamation (effective for an 
interim period only) or by State legislation. 

Qualified 501(c)(3) bonds and exempt-facility bonds for govern- 
mentally owned solid waste disposal facilities and for governmen- 
tally owned airports and docks and wharves are not subject to the 



' The agreement continues the present-law exceptions for private activity bonds issued as part 
of the Texas Veterans' Land Bond Program and the Oregon Renewable Source Energy Program, 
and adds a new exception for a limited amount of bonds issued as part of the Iowa Industried 
New Jobs Training Program. 

^ Bond-financed residential rental projects must satisfy new continuous compliance and 
annual certification requirements. Additionally, owners of such projects must elect to satisfy one 
of two low-income occupancy requirements: 40 percent of the residential rental units occupied 
by individuals having incomes of 60 percent or less of area median income, or 20 percent of such 
units occupied by individuals having incomes of 50 percent or less of area median income. All 
income determinations are made with family-size adjustments. 

^ The sunset for small-issue bonds for manufacturing facilities is extended one additional year, 
through December 31, 1989. Additionally, issuance of these bonds for first-time farmers is treat- 
ed as issuance for manufacturing. The present December 31, 1986, sunset is retained for small- 
issue bonds other than for manufacturing facilities. 

■* The sunset date for qualified mortgage bonds is extended one additional year, through De- 
cember 31, 1988. 



67 

new volume limitation. Qualified veterans' mortgage bonds remain 
subject to their present-law volume limitation. 

4. Arbitrage and related restrictions 

Interest on arbitrage bonds is taxable under present law. Arbi- 
trage bonds are bonds more than a minor portion of the proceeds of 
which are invested in materially higher yielding, taxable obliga- 
tions. IDBs and qualified mortgage bonds are subject to additional 
arbitrgige restrictions that require rebate to the Federal Govern- 
ment of arbitrage profits on obligations unrelated to the purpose of 
the borrowing and the amount of bond proceeds that may be in- 
vested in such obligations is restricted. 

The conference agreement makes several modifications to the ar- 
bitrage and related restrictions applicable to all tax-exempt bonds, 
including the following: 

(1) Rebate requirements, similar to the present-law IDB rules, 
are extended to all tax-exempt bonds. (Mortgage revenue bonds are 
subject to the present-law qualified mortgage bond rules.) An ex- 
ception is provided for bonds to finance operations of certain small 
general purpose governmental units, and a special safe-harbor rule 
is provided for use in determining the amount of the rebate on so- 
called tax- and revenue-anticipation notes. 

(2) Yield on all tax-exempt bonds is determined under the arbi- 
trage restrictions using the original issue discount rules of the 
Code (i.e., the State of Washington case is reversed). 

(3) New temporary period restrictions are imposed on pooled fin- 
ancings and on advance refundings. 

(4) The minor portion of bond proceeds which may be invested at 
unrestricted yield is limited to an amount equal to the lesser of five 
percent or $100,000. The amount of actual bond proceeds that may 
be used to fund a debt service reserve fund is limited to 10 percent 
unless the Treasury approves a greater amount for a specific issue. 
As under present law, amounts deposited in such reserve funds 
may be invested without regard to arbitrage yield restrictions (but 
are subject to the rebate requirement) up to the allowed 10 percent 
amount. 

(5) Certain letter of credit fees (like bond insurance premiums) 
are treated as interest expense to the extent that the fees represent 
a charge for transfer of credit risk. 

(6) The Treasury Department is authorized to waive loss of tax- 
exemption for certain late or erroneous rebate payments, if the 
error is not due to willful disregard of the rebate requirement. 

(7) Restrictions are placed on investment of bond proceeds in de- 
ferred compensation arrangements and other investment type 
property. 

Under the conference agreement, advance refundings are permit- 
ted for governmental and qualified 501(c)(3) bonds, subject to a limi- 
tation of two advance refundings per issue (one advance refunding 
in the case of bonds originally issued after 1985) and various other 
restrictions. 

5. Changes in use of bond-financed facilities 

The conference agreement provides that in addition to loss of 
tax-exemption on bond interest where provided under present law. 



68 

certain amounts paid in connection with bond-financed property 
that ceases to be used in a use qualifying for tax-exempt financing 
may not be deducted for Federal income tax purposes. In general, 
the nondeductible amount is equal to the interest (or the equiva- 
lent thereof) paid on bond-financed loans. 

6. Miscellaneous requirements 

The conference agreement provides that, for most private activi- 
ty bonds, at least 95 percent of the proceeds must be spent for the 
exempt purpose of the borrowing. In the case of Federally guaran- 
teed student loan bonds, this amount is 90 percent. 

The conference agreement generally limits the amount of costs of 
issuance that may be paid from private activity bond proceeds to 
two percent and further provides that amounts paid for costs of is- 
suance are not treated as spent for the exempt purpose of the bor- 
rowing (i.e., are not counted in determining whether the 95 per- 
cent, etc. requirement, described above, is satisfied). 

The public approval requirements that currently apply to IDBs 
are extended to all private activity bonds. Additionadly, the restric- 
tion on maturity of IDBs is extended to qualified 501(c)(3) bonds, 
and qualified 501(c)(3) bonds (other than hospital bonds) are subject 
to a $150 million per institution limit on outstanding bonds. Cer- 
tain bond-financed facilities are also required to be owned by or on 
behalf of a governmental unit (in the case of qualified 501(c)(3) 
bonds, a governmental unit or section 501(c)(3) organization). 

The conference agreement extends to all tax-exempt bonds infor- 
mation reporting requirements similar to the requirements that 
presently apply to IDBs, student loan bonds, qualified 501(c)(3) 
bonds, and mortgage revenue bonds. 

Under the conference agreement, the amount of depreciable 
farm property which may be financed with small-issue tax-exempt 
bonds is limited to $250,000 per person (including related persons). 

7. Effective dates 

The provisions of the conference agreement generally apply to 
all bonds issued after August 15, 1986. In the case of provisions and 
bonds covered under the Joint Statements on Effective Dates of 
March 14, 1986, and July 17, 1986, the conference agreement is ef- 
fective for bonds issued on or after September 1, 1986 (3:00 p.m. 
E.D.T., July 17, 1986, in the case of application of the arbitrage 
rebate requirement to certain pooled financings.) Certain arbitrage 
and related restrictions apply to bonds issued after December 31, 
1985 (September 25, 1985, in the case of so-called "pension bonds"). 
Transitional exceptions are provided for certain amendments in- 
cluded in the conference agreement. 

B. General Stock Ownership Corporations (GSOCs) 

The conference agreement repeals the Code provisions relating to 
General Stock Ownership Corporations (GSOCs) as deadwood, effec- 
tive January 1, 1984. 



Title XIV. Trusts and Estates; Minor Children; Gift and Estate 
Taxes; Generation-Skipping Transfer Tax 

A. Income Taxation of Trusts and Estates 

1. Tax rate schedule 

The rate schedule applicable to the retained income of trusts and 
estates is compressed as compared with the rates applicable to indi- 
viduals. The first $5,000 of taxable income of trusts and estates is 
taxed at 15 percent, with any excess taxed at 28 percent. The bene- 
fit of the 15-percent rate is phased out between $13,000 and $26,000 
of taxable income. 

2. Grantor trust rules 

Under the conference agreement, the income of a trust generally 
is taxed to its grantor if the trust corpus will revert to the grantor 
or the grantor's spouse at any time. An exception is provided 
where the trust may revert only after the death of the income ben- 
eficiary of the trust who is a lineal descendant of the grantor. 

This provision applies to transfers in trust made after March 1, 
1986, with an exception for certain trusts created pursuant to a 
binding property settlement entered into before March 1, 1986. 

3. Taxable years of trusts 

The conference agreement requires that existing and newly cre- 
ated trusts, other than wholly charitable trusts, adopt a calendar 
year as their taxable year. This provision applies for taxable years 
beginning after December 31, 1986. 

4- Trusts and estates to make estimated payments of income 
tax 

The conference agreement requires that new and existing estates 
after their second taxable year and trusts pay estimated tax in the 
same manner as individuals. Also, the conference agreement re- 
pe£ds the rules that permit estates to pay tax over four equal in- 
stallments. This provision is effective for taxable years beginning 
after December 31, 1986. 

B. Unearned Income of Children Under Age 14 

Under the conference agreement, all of the unearned income of a 
child under age 14 in excess of $500 is taxed to the child at the top 
marginal rate of his or her parents. This rule applies to any tax- 
able income of the child reduced by the $500 of standard deduction 
that the child may allocate to unearned income. Thus, the provi- 
sion generally applies only to unearned income of the minor child 
in excess of $1,000. 

This provision generally is effective for taxable years beginning 
after December 31, 1986. 

(69) 



70 

C. Gift and Estate Taxes 

1. Filing information for estate tax current use valuation elec- 

tions 

Where an executor of an estate of an individual dying before 
1986 elected current use valuation on a timely filed estate tax 
return by providing substantially all the information elicited by 
the return form, the executor will have an additional 90 days, after 
being notified by the IRS, to supply any missing information. This 
provision is effective on enactment of the bill, with a special target- 
ed transitional exception. 

2. Gift and estate tax deductions for certain conservation 

easement donations 

Deductions for contributions of certain interests in real property 
to charitable organizations, to the United States, or to a State or 
local governmental unit are allowed for Federal gift and estate tax 
purposes even if the contributions do not meet the requirement for 
deductibility for Federal income tax purposes that the contribu- 
tions be for conservation purposes. 

This provision is effective for contributions made after December 
31, 1986. A targeted transition rule is provided for certain contribu- 
tions to the Acadia National Park in Maine. 

3. Special relief for the Estate of James H. W. Thompson 

Special relief is provided for certain Thai artifacts that were in- 
directly contributed by James H. W. Thompson to a charitable or- 
ganization for the benefit of the Thai people. 

D. Generation-Skipping Transfer Tax 

The conference agreement amends the present generation-skip- 
ping transfer tax to impose a flat-rate tax both on transfers involv- 
ing a sharing in benefits by more than one generation and on 
direct transfers that skip generations. A $1 million per transferor 
specific exemption is provided, with transfers in excess of that 
amount being subject to tax at a rate equal to the maximum gift 
and estate tax rate. In addition, the conference agreement provides 
an additional exemption of $2 million per donee against the tax on 
direct skips to grandchildren, until January 1, 1990. 

The provision is effective generally for testamentary transfers 
made after the date of enactment and for inter vivos transfers 
made after September 25, 1985. 



Title XV. Compliance and Tax Administration 

A. Penalties 

1. Penalty for failure to file information returns or statements 

The conference agreement consolidates the present-law penalty 
for failure to file an information return with the IRS and the 
present-law penalty for failure to supply a copy of the information 
return to the taxpayer. The conference agreement also provides a 
new penalty for failure to include correct information on an infor- 
mation return. This applies to information returns the due date for 
which is after December 31, 1986. 

2. Increase in penalty for failure to pay tax 

The conference agreement increases the penalty for failure to 
pay taxes from one-half of one percent under present law to one 
percent after the IRS notifies the taxpayer that the IRS will levy 
upon the assets of the taxpayer. This applies to amounts assessed 
after December 31, 1986. 

3. Negligence and fraud penalties 

The conference agreement expands the scope of the negligence 
penalty by making it applicable to all taxes under the Code. The 
conference agreement also provides that failure to report on a tax 
return any amount reported on an information return is consid- 
ered negligence in the absence of clear and convincing evidence to 
the contrary. The conference agreement modifies the fraud penalty 
by increasing the rate to 75 percent but applying the penalty only 
to the amount of the underpayment attributable to fraud. These 
provisions are effective for returns the due date of which is after 
December 31, 1986. 

4. Penalty for substantial understatement of tax liability 

The conference agreement increases the penalty for substantial 
understatement of tax liability from 10 to 20 percent of the amount 
of the underpayment of tax attributable to the understatement. 
This is effective for returns the due date of which is after Decem- 
ber 31, 1986. 

B. Interest Provisions 

1. Differential interest rate 

The conference agreement provides that the Government pays 
interest to taxpayers at the Federal short-term rate plus two per- 
centage points, and that taxpayers pay interest to the Government 
at the Federal short-term rate plus three percentage points. These 
rates are adjusted quarterly, and apply to interest for periods after 
December 31, 1986. 

(71) 



72 

2. Interest on accumulated earnings tax 

The conference agreement provides that interest is imposed on 
underpayments of the accumulated earnings tax from the due date 
of the tax return with respect to which that tax is imposed. This 
applies to returns the due date for which (determined without 
regard to extensions) is after December 31, 1985. 

C. Information Reporting Provisions 

1. Real estate transactions 

The conference agreement provides that the person responsible 
for closing a real estate transaction must provide an information 
report on the transaction. This is effective beginning January 1, 
1987. 

2. Persons receiving Federal contracts 

The conference agreement requires Federal executive agencies to 
provide information reports on contracts that they enter. Reporting 
is required beginning January 1, 1987. 

3. Royalties 

The conference agreement modifies current information report- 
ing requirements for royalties, effective January 1, 1987. 

4. Taxpayer identification numbers of dependents 

The conference agreement requires that any taxpayer claiming a 
deduction for a dependent who is at least five years old must report 
the taxpayer identification number of that dependent on that tax 
return, effective for returns required to be filed after December 31, 
1987. Special rules are provided for religious groups exempt from 
social security taxes. 

5. Modification of separate mailing requirement 

The conference agreement modifies the separate mailing require- 
ment for information reports on interest, dividends, patronage divi- 
dends, and royalties, effective for those returns required to be filed 
after December 31, 1986. 

6. Tax-exempt interest 

The conference agreement requires that tax-exempt interest be 
shown on tax returns filed after December 31, 1987. 

7. State and local taxes 

The conference agreement does not include the provision of the 
House bill requiring information reporting on state and local taxes. 

D. Tax Shelters 

1. Tax shelter user fee 

The conference agreement does not include the tax shelter user 
fee provision of the Senate amendment. 



73 

2. Tax shelter registration 

The conference agreement conforms the tsix shelter ratio compu- 
tation (used to determine whether a tax shelter must register with 
the IRS) more closely to the new tax rate schedule. 

3. Tax shelter penalties 

The conference agreement increases the penalties for failure to 
register a tax shelter, for failure to report a tax shelter identifica- 
tion number, and for failure to maintain lists of tax shelter inves- 
tors, effective on the date of enactment. 

4. Tax shelter interest 

The conference agreement provides that sham or fraudulent 
transactions are subject to the increased rate of interest on under- 
payments of tax attributable to tax-motivated transactions. The 
conference agreement does not include the Senate provision in- 
creasing the rate of this interest. 

E. Estimated Tax Payments 

The conference agreement increases from 80 to 90 percent the 
proportion of the current year's tax liability that individual tax- 
payers must make £is estimated tax payments in order to avoid the 
estimated tax penalty, effective for taxable years beginning after 
December 31, 1986. The conference agreement also requires that 
tax-exempt organizations subject to the unrelated business income 
tax and private foundations subject to the excise tax on their net 
investment income must make quarterly estimated payments of 
those taxes, effective for taxable years beginning after December 
31, 1986. 

F. Tax Litigation and Tax Court 

1. Awards of attorney's fees in tax cases 

The conference agreement extends permanently with several 
modifications the provision of present law authorizing awards of at- 
torney's fees in tax cases. These modifications relate to the basis 
for such awards. The present-law burden of proof is unchanged. 

2. Exhaustion of administrative remedies 

The conference agreement provides that failure to exhaust ad- 
ministrative remedies is an additional basis for the Tax Court to 
impose a discretionary penalty. 

5. Report to Congress on Tax Court inventory 

The conference agreement provides that the Treasury and the 
Tax Court will report to Congress every two years on the Tax 
Court inventory. 

4. Tax Court provisions 

The conference agreement permits the Tax Court to impose a 
practice fee, clarifies that the Tax Court has jurisdiction over the 
penalty for failure to pay tax, clarifies that the Tax Court may 
obtain the assistance of U.S. Marshals, clarifies the pay and travel 
rules pertaining to Special Trial Judges, permits a judge to elect to 



74 

practice law after retirement and receive retirement pay, allows in- 
terlocutory appeals to be certified to the Court of Appeals, and con- 
forms the survivor's annuity provisions to those applicable to the 
District Court. 

G. Tax Administration Trust Fund 

The conference agreement does not include the Senate provision 
establishing a Tax Administration Trust Fund. 

H. Tax Administration Provisions 

1. Suspend statute of limitations during prolonged dispute 

over third-party records 

The conference agreement provides that, if a dispute between the 
IRS and a third-party recordkeeper is not resolved within six 
months, the statute of limitations is suspended until the issue is re- 
solved. 

2. Authority to rescind notice of deficiency 

The conference agreement gives the IRS authority, if the taxpay- 
er consents, to rescind a statutory notice of deficiency. 

3. Authority to abate interest 

The conference agreement gives the IRS the authority to abate 
interest attributable to error or delay by an IRS employee in per- 
forming a ministerial act. 

4. Suspension of compounding when underlying interest is 

suspended 

The conference agreement suspends the compounding of interest 
in circumstances in which the underlying interest on the deficiency 
is also suspended. 

5. Additional exemption from levy 

The conference agreement exempts from IRS levy military serv- 
ice disability benefits. 

6. Rules applicable to forfeiture 

The conference agreement conforms the rules in the Code appli- 
cable to forfeiture to the parallel Customs provisions. 

7. Certain recordkeeping requirements 

The conference agreement provides that IRS special agents arei 
subject to the same income inclusion and recordkeeping rules that 
other law enforcement officers are with respect to use of an auto- 
mobile. 

8. Disclosure of return information to certain large cities 

The conference agreement authorizes the Treasury to exchange 
tax return information with any city with a population exceeding 
two million that imposes an income or wage tax. 



75 

/. Modification of Withholding Schedules 

The conference agreement requires employees to file revised 
withholding certificates by January 1, 1988. The conference agree- 
ment also instructs the Treasury Department to modify withhold- 
ing schedules to better approximate actual tax liability under the 
conference agreement. 

/. Report on Return-Free Tax System 

The conference agreement requires the Treasury Department to 
report to the Congress on the potential for implementing a return- 
free tax system for individuals. The report is due not later than six 
months after enactment. 



Title XVI. Exempt and Nonproflt Organizations 

A. Exchanges and Rentals of Membership Lists of Certain Tax- 

Exempt Organizations 

The conference agreement provides an exception from the unre- 
lated business income tax, in the case of tax-exempt organizations 
eUgible to receive tax-deductible charitable contributions, for 
income from exchanges or rentals of donor or member lists with or 
to other such tax-exempt organizations, effective for transactions 
occurring after the date of enactment. 

B. Distribution of Low-Cost Articles by Charities 

The conference agreement provides an exception from the unre- 
lated business income tax, in the case of tax-exempt organizations 
eligible to receive tax-deductible charitable contributions, for 
income from certain distributions of low-cost articles incidental to 
soliciting charitable contributions, effective for distributions occur- 
ring after the date of enactment. 

C. Expansion of Exception from Unrelated Business Income Tax for 

Qualified Trade Shows 

The present-law exception from the unrelated business income 
tax for qualified trade show or convention activities of trade asso- 
ciations, labor unions, or agricultural organizations is expanded tc 
cover (1) qualified trade shows or conventions at which suppliers tc 
the sponsoring organization's members sell products or services^ 
and (2) qualified trade show and convention activities of charitable 
organizations (sec. 501(c)(3)) and social welfare organizations (sec. 
501(c)(4)), effective for taxable years beginning after the date of en- 
actment. 

D. Tax-Exempt Status for Certain Title-Holding Companies 

The conference agreement adds a new category of section 501(c; 
tax-exempt organizations consisting of title-holding companies that 
have up to 35 related or unrelated tax-exempt organizations as 
shareholders or beneficiaries, if certain conditions are met. This 
provision is effective for taxable years beginning after December 
31, 1986. 

E. Exception to Membership Organization Deduction Rules 

Membership organizations engaged primarily in the gathering 
and distribution of news to their members for publication are per 
mitted to deduct expenses relating to the furnishing of goods anc 
services to members from income whether or not derived fronr 
members, effective on the date of enactment. 

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77 

F. Tax-Exempt Status for Technology Transfer Organization 

Under the conference agreement, the Washington Research 
Foundation, an organization that transfers technology from univer- 
sities and scientific research organizations to the private sector, is 
treated as a tax-exempt charitable organization, effective on the 
date of enactment. 



Title XVII. Other Provisions 

A. Targeted Jobs Tax Credit 

The conference agreement extends the targeted jobs credit for 
three additional years, i.e., for first-year wages paid to individusds 
who begin work for the employer before 1989. Under the confer- 
ence agreement, the credit for first-year wages is reduced from 50 
percent to 40 percent; wages paid in the second year of a targeted 
individual's employment are not eligible for the credit; and the 
credit is not available if the employee works less than 90 days (14 
days in the case of qualified summer youth employees) or 120 hours 
(20 hours in the case of qualified summer youth employees). These 
modifications to the credit apply with respect to individuals who 
begin work for the employer after 1985. 

B. Collection of Diesel Fuel and Gasoline Excise Taxes 

Diesel fuel tax. — Under the conference agreement, the diesel fuel 
excise tax for highway use may be imposed on the sale from a 
wholesaler to a retailer of the fuel (or by the manufacturer where 
the sale is direct to the retailer), at the election of a qualified re- 
tailer, effective for sales of diesel fuel for use in highway vehicles 
after the first calendar quarter beginning more than 60 days afteit 
the date of enactment of the bill. 

Gasoline tax. — The present rules under which collection of the 
manufacturers excise t£ix may be deferred to the wholesale level 
are repealed, effective January 1, 1988. The Treasury is directed tc 
study the incidence of evasion of the gasoline tax and to report tc 
the Congress by December 31, 1986. 

C. Social Security and FUTA Provisions 

1. Allow ministers to reelect social security coverage 

The conference agreement provides for a one-time irrevocable 
election back into social security coverage (and the self-employ- 
ment tax) for ministers who had previously elected out on religious 
grounds, effective for taxable years beginning on or after the data 
of enactment. 

2. FUTA for certain Indian tribes 

FUTA taxes assessed against certain Indian tribes for the period 
of time they are refused unemployment compensation coverage b> 
the State are excused. This provision is effective with respect tc 
services performed before, on, or after the date of enactment, and 
before January 1, 1988. 

3. Treatment of certain technical personnel 

Section 530 of the Revenue Act of 1978 does not apply to services 
provided pursuant to an arrangement between the taxpayer and 

(78) 



79 

another organization whereby the individual provided services as 
an engineer, designer, drafter, computer programmer, systems ana- 
lyst, or other similarly skilled worker engaged in a similar line of 
work for such other organization, effective for services rendered 
after the date of enactment. 

D. Tax Code Inference 

The conference agreement enacts into law the Internal Revenue 
Code of 1986. That is, the conference agreement reenacts the provi- 
sions of the 1954 Code — as in effect on the date of enactment of the 
bill — together with amendments £is made by the conference agree- 
ment. Under the conference agreement, no provision of the Inter- 
nal Revenue title that was in effect on August 16, 1954 is to apply 
in any case where its application would be contrary to any treaty 
obligation of the United States in effect on the date of enactment 
of the 1954 Code. 

E. Miscellaneous Provisions 

1. Foster care payments 

The present-law exclusion for certain foster care payments is ex- 
tended to cover such pa5mients for care of adults as well as chil- 
dren, and is modified to eliminate the requirement of detailed rec- 
ordkeeping, effective for taxable years beginning on or after Janu- 
ary 1, 1987. 

2. Rules for spouses of Vietnam MIAs 

The conference agreement reinstates and makes permanent cer- 
tain expired provisions relating to Vietnam MIAs, effective for tax- 
able years beginning after 1982. 

3. Exempt certain reindeer income from tax 

The conference agreement provides that income derived directly 
from the sale of reindeer or reindeer products as provided in the 
Reindeer Industry Act of 1937 is exempt from Federal income tax- 
ation. This provision applies as if originally included in the related 
provision of the 1937 Act. 

4. Certain quality control studies for AFDC and Medicaid 

The conference agreement provides revised deadlines for a study 
to be conducted by the Department of Health and Human Services 
(HHS) and the National Academy of Sciences (NAS) of quality con- 
trol measures in connection with the administration of the Aid to 
Families with Dependent Children and Medicaid programs, and for 
publication by HHS of regulations relating to such quality control 
measures. 



Title XVIII. Technical Corrections 

This title contains technical, clerical, conforming, and clarifying 
amendments to provisions enacted by the Tax Reform Act of 1984, 
the Retirement Equity Act of 1984, and other recently enacted tax 
legislation, as well as similar amendments to nontax provisions of 
the Deficit Reduction Act of 1984. 

O 



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63-115 (96)